An “All Cash” situation does happen quite often. For whatever personal reasons, some people desire to own their home free and clear. The psychology of cash, or course, gives the buyer a negotiating advantage in the acquisition process; but like all other situations, it does have its Pros and Cons. Let’s take a look at some of these.
PRO – Benefits of Owning Your Home Free and Clear:
1. It does give people a sense of security. While you can’t put a dollar figure on this benefit, it is a motivating factor.
2. It eliminates the necessity of making payments on a mortgage. This, of course, means that there is no reverse cash flow in owning the home with the exception of maintenance, insurance and taxes.
These benefits have many side effects, but they all seem to basically relate to security and cash flow. Because it’s people that really count, the above mentioned benefits may outweigh all of the economical benefits that point to a direction other than owning one’s home free and clear.
CON – Basic Leverage in Owning Real Estate That is Not Free and Clear:
In looking at this side of the picture, we are going to compare to owning a house which is free & clear of encumbrances. For purposes of our comparison let’s assume that you are going to buy a $200,000 home in which to live. And let’s assume that you have the $200,000 and can pay ALL CASH – $200,000.
Let’s also assume that we have appreciation taking place in your area which is a constant 6% per year. So, your home would be worth $212,000 at the end of one year. If instead of buying the home for “All Cash”, let’s say you purchase it with 20% down or $40,000 and you owe $160,000 on a 5% mortgage. The interest would be 8,000 for the first year. If your house increased in value $12,000 in the first year, your earnings for the first year would be $4,000. If you paid $8,000 in interest and you house appreciated $12,000, the difference is $4,000. In addition, your equity (the Loan less Loan Reduction) increase the first year would be $2,360. Your total earnings the first year would be $6,360.
Remember, of the original $200,000 in capital, you have only used $40,000. You can now take another $30,000 and buy a home valued at $150,000 for rental purposes. Now you would owe $120,000 at 7% (probably higher than 5% for income property), which is $8,400 in interest per year. If you are a reasonably good business person, you should be able to buy a house of this value that you could rent for at least $100.00 more than it takes to make the monthly payments which would be $1,200 profit per year. In addition to that, you would have the same $9,000 appreciation or 6% of the $150,000 value of the house. so, the appreciation plus the $1,200 from the rental would get you $10,200 per year. You deduct the $8,400 interest you pay on the $120,000 loan and find that you earned $1,800. that first year on the rental house. In addition, your equity increase (loan balance reduction) would be $1,219 making your total earnings for the first year $3,619.
Remember, you only used $30,000 of the $160,000 that remained of your original capital. Let’s assume that you could buy five of these rental houses with $30,000 down in addition to the home you bought for yourself. If you purchased five of these rental homes similar to the example, each of them earning you $3,619 per year, you would receive $18,095 in earnings per year from your rental houses. In addition to that, you had $6,360 earnings from your own home that you purchased which would deliver then a total of $24,455 in earnings per year on the $190,000 cash investment, or a return of 12.2% per year -vs- 2% you had on purchasing one home for ALL CASH. * And you have $10,000 cash left over for reserve.
In addition, you would have other benefits, such as tax shelter on your investments, which can be expressed in dollars. We are not attempting here to analyze this situation. Our purpose is to show the use of leverage in its simplest form. This is an EXAMPLE of the use of the money in other than a cash sale.
The above, of course, is merely a cursory exploration of the benefits of leverage versus the ALL CASH purchase. The benefits in each person’s mind would dictate their choice. This comparison merely develops both sides of the question for your perusal.
This is not to be considered to be investment advice. Any person considering investing should communicate with experienced investment advice from competent people in their own geographical area.
Some of the information for this article was excerpted from Robert W. Steele’s book “50 ways to Acquire Real Estate”.
These posts are the opinion of the author who is not engaged in rendering legal, accounting, or investment advice. If such advice is required or desired, the services of competent professional persons should be sought.
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