March 6, 2000, Revised August 31, 2007

An all-cash purchase should be viewed as a "no-mortgage" investment. The return is the rate you would other have paid on the mortgage but now avoid. This return can be compared to that of other investments in terms of return, risk and liquidity. To make valid comparisons, however, it must be assumed that the house purchaser who elects a no-mortgage investment saves an amount every month that is equal to the payment he would have had to make had he taken the mortgage. The mortgage is a forced-saving device.

The No-Mortgage Investment

"My wife and I are both in our late 20s and would like to buy a home for $250,000. We have $500,000 in available assets, including cash, stock, and bonds, as well as $100,000 in retirement assets. We have no debt. We can afford to pay cash for the home. Should we? What should we consider in making that decision?"

An all-cash purchase should be viewed as an investment. The investment is not the house, because you are buying the house, and will enjoy any appreciation in its value, whether you pay all cash or take out a mortgage. The investment in an all-cash transaction is the mortgage you avoid. It might be called a "no-mortgage" investment.

Suppose, for example, the alternative to an all-cash transaction is a $200,000 mortgage at 8.5% with no additional costs. If you pay the $200,000 in cash instead, your return on that cash is the 8.5% that you would have paid on the mortgage.

Comparing Alternative Investments

In considering whether investment in the no-mortgage is wise, you compare it to your other investments with respect to three things: return, risk and liquidity. The no-mortgage investment has a return of 8.5%, it is risk-free, and it provides some but not high liquidity. Since your home would have no liens on it, you could easily obtain cash in a few days with a home equity loan.

Compare this investment to your other assets. Your cash assets carry a lower return, probably have very low risk, but offer the highest liquidity. You want some of your assets in this form, but not more than you need for every day use and for emergencies.

Your bonds may have a higher or lower return, depending on their risk category. Adjusted for risk, however, they are an inferior investment to the no-mortgage. Only US Government bonds are risk free, and they yield 1-2% less than the no-mortgage. Furthermore, bonds are not very liquid in the small amounts you would sell. I prefer the no-mortgage over bonds.

Stocks in contrast generally earn a higher return than the no-mortgage, but they also carry the risk of price fluctuations. You are young and can afford to have stocks comprise a significant portion of your portfolio. But also because you are young, you have no experience with protracted declines in the stock market, and might be inclined to overdo it.

If I had your portfolio and was your age, I think I would hold about $50,000 in cash assets, $200,000 in a diversified portfolio of common stock, and a mortgage-free house. But that's a "conservative" portfolio, and no doubt it is influenced by the fact that I am not in fact your age.

An Important Proviso: The Mortgage as a Forced Saving Device

"In a recent article, you said that paying all cash for a house made sense if the investment return on the cash was lower than the mortgage rate. But my numbers show otherwise. I am currently earning 5.5% on 200K invested in a money market fund, and the mortgage offered me has a rate of 7.75%. If I pay cash for the house, I save $315,818 in mortgage interest over 30 years. But if I take the mortgage and invest the 200K at 5.5%, after 30 years I have $1, 037, 478. Is there something wrong with my logic?”

Yes. Comparing interest payments in one case with future wealth in another is comparing apples and oranges. You should compare future wealth in one case with future wealth in another.

Furthermore, you’re forgetting that if you take the mortgage, you must make monthly mortgage payments to the lender of $1432.83, whereas if you pay cash, you don’t make these payments.

Your calculation that you would have $1,037,478 after 30 years if you take the mortgage and invest the 200K at 5.5% is correct. Your wealth in the all-cash transaction is the value of $1432.83 invested every month in the money market fund. This turns out to be $1,309,051. You will have more wealth if you pay cash, which is consistent with the principle that paying cash is preferable if the return on investment is below the mortgage rate.

But this example reveals an important proviso: to be better off in the future from paying cash, you must invest the same monthly payment that you would have made if you had borrowed. With the mortgage, you don't have to think about this because you must make the payment, but without the mortgage it becomes voluntary. If the $1432.83 you pay the lender in the mortgage case is spent in the all-cash case, you will end up substantially poorer paying all-cash.

Some time after writing this article, I developed a spreadsheet called Future Net Worth, which can be downloaded to your computer. The spreadsheet allows you to measure your future net worth on the assumption that you pay all cash, then measure it again on the assumption that you take a mortgage, and see where you end up in each case. The spreadsheet calculates your net worth year by year in both cases. For further discussion, see Pros and Cons of Paying Cash For a House.