Author Topic: Buy Home in Cash?  (Read 1961 times)

nickelwise

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Buy Home in Cash?
« on: January 09, 2024, 02:59:40 PM »
Hello my fellow Mustachians,

I'm in my 30's and currently rent an in-law apartment. My landlord is going to be selling the house, so my intention is to buy it from him and continue to rent out the main unit, transitioning from a renter to a "house hacker". I see myself as perhaps 2-3 years from FIRE.

My options as I see them are:

1) Take out a mortgage, which currently has higher interest rates than recent history. Plan to refinance once rates come down. Of course, this means I'm paying loan closing fees (at least) twice, and high interest while waiting for rates to come down. I'd tie up a lot of my salary with monthly expenses (even with the rental income), and my ongoing investment would be limited to maxing my tax-advantaged vehicles, at least until I could refinance.

2) If I empty out my taxable investments, I should have just enough money to buy the house in cash. This will cost me something like $16k in capital gains taxes, whereas if I only sold these investments during FIRE, I might not incur any. I'm probably dodging $16k in first-year interest alone, along with two sets of loan closing fees. I'm obviously losing all potential gains on the investments I'm selling. With no mortgage payment, for every month in which I collect rent, it should cover all my living expenses, including income tax on the rent, and I'd be essentially able to invest 100% of my salary.

3) Hold off buying a house in the current environment. Find a new living arrangement, since my current home will be sold out from under me, and wait for a better opportunity. Moving costs, in dollars, time, and stress. Unlikely to find a housing arrangement as ideal as my current one during this interim.

If a mortgage is something like 7%, and the market averages 10%, then on average, taking out the mortgage seems like a better deal. So is it a psychological barrier I need to overcome, and stick with the market? I don't know if I'm so eager to bet on my portfolio "winning the race" when the margins are that tight (compared to racing a 3% mortgage, for example). It's the equivalent of taking out a 7% loan and putting the entire thing into the market. Is that a good deal? Is it increasing my sequence of returns risk too much when I'm close to FIRE, to be taking the mortgage option? Is it better to essentially lock in a 7% return by liquidating the taxable portfolio now?

Also, if I still have the high monthly expense post-FIRE, I may have less flexibility for zeroing in my income to whatever point I want it to hit to maximize benefits (taxes, ACA, Roth conversion ladder, etc.)

I suppose I'd be giving up a bit of mortgage interest deduction I might otherwise take against schedule C income, if I did the cash option.

Something about the low monthly expense of the cash option feels better, psychologically. Although along the same lines, emptying the taxable portfolio might be a difficult trigger to pull!

Thoughts and advice?

Freedomin5

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Re: Buy Home in Cash?
« Reply #1 on: January 09, 2024, 04:00:07 PM »
How long would it take you to rebuild the taxable account? How expensive is the house? Are we talking about millions or just a couple hundred thousand? Is the house likely to appreciate in value over time?

Telecaster

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Re: Buy Home in Cash?
« Reply #2 on: January 09, 2024, 04:16:42 PM »
If a mortgage is something like 7%, and the market averages 10%, then on average, taking out the mortgage seems like a better deal. So is it a psychological barrier I need to overcome, and stick with the market? I don't know if I'm so eager to bet on my portfolio "winning the race" when the margins are that tight (compared to racing a 3% mortgage, for example). It's the equivalent of taking out a 7% loan and putting the entire thing into the market. Is that a good deal? Is it increasing my sequence of returns risk too much when I'm close to FIRE, to be taking the mortgage option? Is it better to essentially lock in a 7% return by liquidating the taxable portfolio now?

I'm not sure there's a hard rule about when it makes sense to avoid or pay off a mortgage.    10% is > 7%, but 7% is a sure thing, right?   And not having the bank involved with the transaction sounds delightful.

The only downside I can see is liquidity.   I recommend you evaluate your situation and consider how likely it is you might need or want that money in the future.   

nickelwise

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Re: Buy Home in Cash?
« Reply #3 on: January 10, 2024, 07:05:19 AM »
Thanks for the thoughts folks. Even the questions you ask help me to think things through myself, aside from being able to give you more info.

How long would it take you to rebuild the taxable account?

Assuming I'm able to collect rent 11 out of 12 months per year, I'm calculating that I should be able to invest about $67,000 per year. That would re-invest the amount I'm liquidating in about 4.5 years (if I chose to continue working that long). Of course, that would be split across taxable and tax-advantaged. Only about half of that would be going to taxable, so 9 years to invest that same amount back into taxable! I don't expect to keep working that long.

How expensive is the house?  Are we talking about millions or just a couple hundred thousand?

About $300,000

Is the house likely to appreciate in value over time?

Hard to say! I'm not too real-estate savvy. Houses have shot up something like 25% around here over these past couple of crazy years. I don't know what the heck will happen next! I don't expect to sell, but it's good to have flexibility.

I'm not sure there's a hard rule about when it makes sense to avoid or pay off a mortgage.    10% is > 7%, but 7% is a sure thing, right?

Absolutely. I feel like earlier in accumulation it makes sense to race an average 10% against a consistent 7%, but closer to RE I'm more attracted to a sure thing.

The only downside I can see is liquidity.

Liquidity definitely takes a hit. But on the other hand, I feel like a low living expense gives me some of the flexibility. I would also be able to setup a HELOC for emergency liquidity.

lucenzo11

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Re: Buy Home in Cash?
« Reply #4 on: January 10, 2024, 08:41:32 AM »
If you are willing, I'd suggest posting all your numbers in a typical case study and then include home details (list price, how much you could rent it for etc) and then you'll get some better analysis and thoughts on your situation.

Or this might be better suited for the real estate/landlording section.

A couple more specific questions:
1. While you will hit FIRE in maybe 2-3 years, do you intend to stop working at that time? I ask mainly due to liquidity and withdrawal strategy. Say you buy in cash and liquidate your taxable, do you have other assets to cover your living expenses or can the rental sustain you for a while? I get that you'll have rental income coming in the door and that could cover living expenses, but I'm just concerned about overall liquidity in the first few years.
2. Would rental income cover a mortgage? Seems like from your post it might not.
3. I'm also just curious about the general aspects of why the current owner is selling. Are they motivated? Do they want out of there ASAP? Do you know what the condition of the main house is? Do they even care how you buy it?

Laura33

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Re: Buy Home in Cash?
« Reply #5 on: January 10, 2024, 09:48:39 AM »
I feel like earlier in accumulation it makes sense to race an average 10% against a consistent 7%, but closer to RE I'm more attracted to a sure thing.

FWIW, that is my view.  IME, going in to FIRE, you should have (1) a paid-off house, (2) 25x living expenses, and (3) a slush fund for things like major capital projects that aren't part of your usual budget (e.g., house needs a new roof, you need a new vehicle -- some folks call that a sinking fund). 

Early on in your career, a mortgage makes sense, because the leverage free up more money to invest in accounts that also provide additional tax benefits, so it's a double win.  And your risk tolerance is pretty high, because you have the steady income stream called a job to rely on.

OTOH, when you FIRE, your risk tolerance becomes lower because you don't have that job providing protection against your downside risks.  So IMO, as you approach FIRE, your focus needs to shift to add in more risk minimization (obv. you still need growth, because you are planning for many decades of retirement, but losing the security provided by the steady income stream means you need to find other ways to replace that security).  And one of the best ways to minimize your downside risk is to go into FIRE with lower expenses and a guaranteed place to live, i.e., a paid-off house. 

Also FWIW, I would not pay attention to whether you think the RE market is going up or not, because none of that matters unless you decide to sell.  You should be buying a house as a place to live for at least 7-10 years, preferably longer, so short-term property market fluctuations are irrelevant. 

nickelwise

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Re: Buy Home in Cash?
« Reply #6 on: January 10, 2024, 10:35:11 AM »
1. While you will hit FIRE in maybe 2-3 years, do you intend to stop working at that time? I ask mainly due to liquidity and withdrawal strategy. Say you buy in cash and liquidate your taxable, do you have other assets to cover your living expenses or can the rental sustain you for a while? I get that you'll have rental income coming in the door and that could cover living expenses, but I'm just concerned about overall liquidity in the first few years.

I do intend to stop working, certainly moving away from a "more than full-time" stressful job, but I like to imagine I may do some lighter work after a decompression period. Rent should come pretty close to covering me if I have no P&I. Assuming I can keep the main house rented 11 months per year, I should only need to withdraw some $5,000 per year to cover remaining expenses. I should easily be able to save more than ten times that in either savings or taxable mutual funds in two years. If something goes wrong where I can't rent out for an extended period, or I have large, early maintenance expenses, or some other emergency, and I need some money urgently, that's where I might get stuck needing to find a way to get money out. I suppose there is SEPP?

2. Would rental income cover a mortgage? Seems like from your post it might not.

If I put 20% down, the after-tax rental income would about cover P&I in the months I'm able to collect rent. Nothing else. When I stop working, the numbers get a little better, since there would be a lot less tax due on the rental income, but my fixed monthly expenses would still be a lot higher.

3. I'm also just curious about the general aspects of why the current owner is selling. Are they motivated? Do they want out of there ASAP? Do you know what the condition of the main house is? Do they even care how you buy it?

Current owner is an out-of-state landlord, now elderly and is looking to get out of managing properties. It's something he's been planning for a while and we've discussed a few times over the years. He's probably not highly concerned with the payment method, and doesn't have any urgency with his timetable. I expect to be able to keep the main unit's current tenant with the current arrangement they already have.

The house is in good shape, as the owner has made some major investments into it over the past few years. Heat (and hot water) has not been updated, though.

---

@Laura33, everything you said mirrors what I've been thinking.

It is a bummer to pay out 16,000 capital gains when I liquidate the portfolio, where I'd otherwise easily harvest it in the zero bracket if I didn't have to touch it while working. But I'm still leaning towards this cash option, which I hadn't even considered until just recently. Until now I'd just been running under the assumption that a mortgage is almost always a better deal.

Laura33

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Re: Buy Home in Cash?
« Reply #7 on: January 10, 2024, 11:31:52 AM »
Current owner is an out-of-state landlord, now elderly and is looking to get out of managing properties. It's something he's been planning for a while and we've discussed a few times over the years. He's probably not highly concerned with the payment method, and doesn't have any urgency with his timetable.

Would he be interested in owner financing?  He might be willing to take a steady stream of income for less than 7%.

nickelwise

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Re: Buy Home in Cash?
« Reply #8 on: January 10, 2024, 11:39:22 AM »
Would he be interested in owner financing?  He might be willing to take a steady stream of income for less than 7%.

That's interesting, I'm not really familiar with this. Is it a common practice? I should probably research this and think about how I might approach him with it.

lucenzo11

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Re: Buy Home in Cash?
« Reply #9 on: January 10, 2024, 12:29:44 PM »
Would he be interested in owner financing?  He might be willing to take a steady stream of income for less than 7%.

That's interesting, I'm not really familiar with this. Is it a common practice? I should probably research this and think about how I might approach him with it.

I had the same thought on considering owner financing when I asked that question. Could be a huge benefit to you in keeping your liquidity and avoiding bank process of mortgage, but yes do your research and see what he says. If he's trying to liquidate then this might not be desirable, but if he just wants to not manage anymore then this is way to keep his investment without any of the headaches associated with it.

Freedomin5

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Re: Buy Home in Cash?
« Reply #10 on: January 11, 2024, 04:36:50 AM »
Agree. Either owner financing or pay in cash sound like good options in this case. At 7% mortgage, I’d also be inclined to pay cash.

nickelwise

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Re: Buy Home in Cash?
« Reply #11 on: January 11, 2024, 07:10:16 AM »
Great to have this input from you all. I was slow to even consider cash, since mortgages have a reputation as the quintessential American wealth-building tool.

uniwelder

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Re: Buy Home in Cash?
« Reply #12 on: January 11, 2024, 07:40:19 AM »
...With no mortgage payment, for every month in which I collect rent, it should cover all my living expenses, including income tax on the rent...

...When I stop working, the numbers get a little better, since there would be a lot less tax due on the rental income, but my fixed monthly expenses would still be a lot higher.

You'll still probably owe income tax on some of the rent, but it might not be as much as you think.  Have you considered depreciation yet?  Here are some made up numbers, that might be close to reality in your case.  With a purchase price of 300k, the land value might be 100k, so value of the home itself would be 200k.  If the main rental is 75% of the square footage, then you have a 150k cost basis for depreciation, which is taken over 27.5 years.  This means you deduct $5,455 (150,000 divided by 27.5) annually from the rental income. 

You would also write off 75% of the expenses for the home.  In the past few years, rules changed so you can now deduct up to 10k per year for repairs or improvements immediately.  If there are things you're looking to take care of while you have your full time job, like the water heater or hvac, those expenses might completely negate the rental income. 

smisk

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Re: Buy Home in Cash?
« Reply #13 on: January 11, 2024, 07:53:31 AM »
I just sold my house and am a bit biased towards not locking up so much cash. If for some reason you needed to sell, it is pretty time and labor-intensive to get that money back out.
But if you really don't see yourself moving soon, you're probably fine - just as long as you don't anticipate a lot of work and money needed to get the house ready to rent out.

liquidsnakes

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Re: Buy Home in Cash?
« Reply #14 on: January 11, 2024, 08:19:48 AM »
You should be able to get a 15 year mortgage in the low 5% range. Cash-out refi rates (if you get a mortgage later) are always higher than a first mortgage, so you probably won't be able to beat that for a while. I've paid cash before to close quickly and get a good deal on properties, but it's always been a pain to get a mortgage later, banks don't seem to like it.
Plus, depending on our other circumstances, may be able to deduct some mortgage interest on taxes.

uniwelder

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Re: Buy Home in Cash?
« Reply #15 on: January 11, 2024, 08:39:16 AM »
...depending on our other circumstances, may be able to deduct some mortgage interest on taxes.

Yes, along the same train of thought as my previous comment about ways to reduce paying income tax on the rent.  You should be able to consider 75% (depending on square footage split) of the mortgage interest, and the same for property tax and home insurance.

To sum up, there is 1) property deprecation, 2) 10k repairs/improvements, 3) mortgage interest, 4) property tax, and 5) insurance.

nickelwise

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Re: Buy Home in Cash?
« Reply #16 on: January 11, 2024, 08:49:13 AM »
But if you really don't see yourself moving soon, you're probably fine - just as long as you don't anticipate a lot of work and money needed to get the house ready to rent out.

Definitely not anticipating much immediate work here. The landlord put in some work and improvements between tenants a couple years ago, and we have a current main unit tenant already, which I see as a great advantage for me.

You'll still probably owe income tax on some of the rent, but it might not be as much as you think.  Have you considered depreciation yet?  Here are some made up numbers, that might be close to reality in your case.  With a purchase price of 300k, the land value might be 100k, so value of the home itself would be 200k.  If the main rental is 75% of the square footage, then you have a 150k cost basis for depreciation, which is taken over 27.5 years.  This means you deduct $5,455 (150,000 divided by 27.5) annually from the rental income. 

You would also write off 75% of the expenses for the home.  In the past few years, rules changed so you can now deduct up to 10k per year for repairs or improvements immediately.  If there are things you're looking to take care of while you have your full time job, like the water heater or hvac, those expenses might completely negate the rental income.

I had figured in some depreciation, but I was not aware that you can deduct up to $10,000 per year immediately for improvements. That is great info!

But say I collect $25,000 per year, deduct $6,000 for depreciation, $7,000 for expenses, my understanding is I'm still paying earned income tax at my marginal rate on $12,000, which between state and federal is something like 28%, or ~$3,400. Not an insignificant chunk!

To sum up, there is 1) property deprecation, 2) 10k repairs/improvements, 3) mortgage interest, 4) property tax, and 5) insurance.

I was assuming that I can also take any landlord-paid utilities, such as water/sewer, trash collection, and so on, is that correct?

You should be able to get a 15 year mortgage in the low 5% range. Cash-out refi rates (if you get a mortgage later) are always higher than a first mortgage, so you probably won't be able to beat that for a while. I've paid cash before to close quickly and get a good deal on properties, but it's always been a pain to get a mortgage later, banks don't seem to like it.
Plus, depending on our other circumstances, may be able to deduct some mortgage interest on taxes.

I hadn't thought about a 15. Doing the math quickly, I'm surprised that my payment looks to be only about $200 higher on $240,000 at 5% for 15 years vs $240,000 at 7% for 30 years. I guess now I have another option on the table. And as you say, I could deduct a percentage of that mortgage interest against schedule C rental income. Can I really get a 5% rate right now?



Lots of great information from everyone! I still have some thinking to do.

uniwelder

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Re: Buy Home in Cash?
« Reply #17 on: January 11, 2024, 08:59:03 AM »
To sum up, there is 1) property deprecation, 2) 10k repairs/improvements, 3) mortgage interest, 4) property tax, and 5) insurance.

I was assuming that I can also take any landlord-paid utilities, such as water/sewer, trash collection, and so on, is that correct?

Yes, I suppose you would deduct 3/4 or so of that expense as well.  I forgot about that.

Must_ache

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Re: Buy Home in Cash?
« Reply #18 on: January 11, 2024, 12:55:28 PM »
I think paying cash sounds sensible since you anticipate being able to get the liquid assets back up.  I'm 52 and if I could get a risk-free 7% after-tax return I would probably put 100% of my assets in it (assuming it would pay interest or dividends that I could live off of).  Or course there is to possibility that the return could be lower down the road and if rates were 5% it would only take so long to recoup refinancing costs, so this argument is way too simple.   
« Last Edit: January 11, 2024, 12:57:50 PM by Must_ache »

Freedomin5

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Re: Buy Home in Cash?
« Reply #19 on: January 11, 2024, 02:15:35 PM »
I just sold my house and am a bit biased towards not locking up so much cash. If for some reason you needed to sell, it is pretty time and labor-intensive to get that money back out.
But if you really don't see yourself moving soon, you're probably fine - just as long as you don't anticipate a lot of work and money needed to get the house ready to rent out.

Getting a HELOC shouldn’t be more time or labor intensive than getting a normal loan at the bank, and probably less labor intensive than getting a mortgage.

Though if OP can get a mortgage in the 5% range, that would change the math a bit.

liquidsnakes

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Re: Buy Home in Cash?
« Reply #20 on: January 11, 2024, 03:01:23 PM »
I just sold my house and am a bit biased towards not locking up so much cash. If for some reason you needed to sell, it is pretty time and labor-intensive to get that money back out.
But if you really don't see yourself moving soon, you're probably fine - just as long as you don't anticipate a lot of work and money needed to get the house ready to rent out.

Getting a HELOC shouldn’t be more time or labor intensive than getting a normal loan at the bank, and probably less labor intensive than getting a mortgage.

Though if OP can get a mortgage in the 5% range, that would change the math a bit.
More expensive though..

 

Wow, a phone plan for fifteen bucks!