In January of 2016, we were headed back home from the high of a 6-month honeymoon in Hawaii. Ready to buckle down and get full-time jobs again, we figured it’d be a good idea to buy a house, so at ages 25 (me) and 26 (Lauren), we wrote a check for $71,000 and purchased a 3-bedroom, 2-bathroom condo in the low-cost city of Gainesville, Florida — mortgage-free.
If everything about that last paragraph makes us seem completely unrelatable, please take a minute to understand how we got the money for all that in the first place. In short, we didn’t have some trust fund, and we didn’t have high-paying Silicon Valley tech jobs either. We just invested the majority of our teacher-level salaries for two years while living in a one-bedroom apartment, sharing one old car, skipping optional bills like cable TV, and working some side hustles like photography (it’s all detailed in our Financial Roadmap).
But none of that is really what this article is all about. I want to talk about our decision to pay cash for that condo, how it actually ended up hurting us financially in the long run, and how others might be able to learn from our experience when deciding whether to accelerate their mortgage payments or avoid taking out a mortgage altogether.
When it comes to paying cash for a house, the benefits are pretty commonly known: You avoid debt, interest, and a large portion of closing costs. You’re also able to act more quickly and make more compelling offers than people who are relying on a lender’s cooperation. For a lot of people, owning a home without ever making a single mortgage payment might seem like “living the dream.”
The major drawback to buying a home for cash is rarely discussed, though: Opportunity cost. If we hadn’t paid cash, we would have taken a mortgage and kept the excess money invested in the stock market instead. Since the stock market has had much higher returns compared to the interest we would have paid by taking a mortgage, we actually lost out on a lot of gains by paying for the property in full. We could have borrowed the money at a low rate and invested it to earn a higher return.
Ultimately, we are actually poorer today in terms of overall net worth than we would have been if we had mortgaged our home. On the other hand, that opportunity cost came with peace of mind and a much lower risk profile.
Our Home: A Fantastic Investment
Before getting into the details of mortgaging a property versus paying cash, it’s worth acknowledging that our condo has actually been an amazing investment in terms of its total return. We haven’t lost money on the deal at all. To calculate the investment return on our condo, let’s look at the difference between revenue and expenses over the 4ish years we’ve owned it.
The “revenue” provided by our condo has come in three main categories: Foregone rent (money we’ve saved by not having to pay rent), rental income (money collected from roommates and tenants along the way), and appreciation in property value.
When calculating investment returns, I prefer to be a little conservative, and estimating foregone rent is tricky. A lot of people would figure this out by taking the monthly rent you’d expect to receive if you rented your house out to someone else, and multiplying it by the number of months you’ve lived there. I think that would be an overestimate. If we didn’t own this place, we would have never rented a 3/2 unit for ourselves. We’d have gotten something much smaller and less expensive, so I have to base our foregone rent “revenue” on that hypothetical, smaller amount.
Rental income from roommates and tenants is extremely straightforward (just add it up), but appreciation of property value takes a little more guesswork. To estimate our home’s present value, I like to take the Zillow Zestimate and lop off 10% to account for transactional fees and negotiations that would happen if we were to sell our place.
Even estimating conservatively, our house is now worth a little over $100k. This means it’s appreciated in value by around 9% per year on average since owning it. That’s an abnormally high rate compared to the 3-4% annualized appreciation on a typical home. It was also pure luck. Nobody should count on appreciation like that, long-term.
Adding it all up over 50 months of homeownership, we found that the total revenue* generated by our house has been $85,202. Unfortunately, revenue isn’t profit, so let’s take a look at the expenses of owning our home:
As you can see, our condo association dues and special assessments have been quite high (though they do cover water, sewage, trash, a clubhouse, a pool, a gym, tennis courts, and many other things). We’ve kept maintenance costs somewhat reasonable by opting for lower-end flooring and fixtures, and doing a lot of work ourselves when things break or need fixing.
Subtracting homeownership expenses of $33,399 from total revenue leaves a net profit of $51,803 from our home over a period of 50 months, which represents an annualized return of 14% overall. That’s a really good annual ROI!
Paying Cash Cost Us Big Time
If we’ve been profiting handily from owning our condo, how could this purchase have possibly been a financial mistake? The answer lies in what would have happened if we’d mortgaged the property instead of paying cash.
At the time we bought the house, we could have gotten a 30-year mortgage on it at about a 4% annual interest rate. Assuming we put 20% down, we’d have had to make a $14,200 down payment, leaving us with an extra $56,000 laying around (compared to the scenario where we paid cash for the house).
When we have extra cash around, it never sits idle. We would have put that money to work for us in the stock market. Actually, we would have left it at work in the stock market, because in reality, we sold stock to buy our condo for cash in the first place.
At the time of writing this article, the annualized total return on the US stock market has been somewhere around 11%** since January 2016. So, had we taken a mortgage and let the $56k ride, it would have been earning 11% per year while we were only paying 4% annually to borrow it in the first place!
Accounting for the mortgage payments that would have come out of that stock market investment along the way*** (which also accounts for the interest paid), the extra cash would have grown from $56k to about $71k (adding about $15k) over the past 50 months. We’d also have knocked another $4k or so off the mortgage balance. Meanwhile, the house would have been producing the same “revenues” (foregone rent and appreciation) for us as it otherwise would.
In short, taking a 30-year mortgage on our condo and investing the difference would have left us about $19,000 richer today overall, compared to paying cash as we did. That’s a lot of money!
Why We Wouldn’t Change a Thing
You’d think that we’d regret leaving $19,000 (and probably more as time moves forward) on the table, but actually, we’d make the same decision again if we had the chance. Even though paying cash for our home didn’t give us the highest return possible, it did put us in a much lower-risk position, keeping us safer in case the economy hadn’t done so well the last four years.
Imagine the following hypothetical scenario: You have $100k in stock investments today, and no other money or debt to your name. You want to buy a $100k house, but instead of selling your stock to pay for it, you take a $100k loan at a low interest rate to pay for it instead, leaving your money invested. Your balance sheet now looks something like this:
Net worth = ($100k stock) + ($100k house) − ($100k debt) = $100,000.
Now, imagine the economy crashes, and the stock market and all real estate prices drop by 50%. You’d think that your net worth would drop by 50% as well, but let’s take a look:
Net worth = ($50k stock) + ($50k house) − ($100k debt) = $0.
Since you put yourself in a leveraged position by taking a loan to pay for your house and investing the difference, your entire net worth was completely wiped out by a 50% asset price decline in the economy. That’s pretty wild!
This leveraged position is exactly what we wanted to avoid by paying cash for our condo. Mathematically, low-interest leverage will most likely boost your investment returns over the long run, but in times of economic turmoil, it’ll hurt twice as bad. This isn’t just hypothetical, either. In the midst of the 2008 financial crisis, stock and real estate prices really did drop by as much as 50%.
Deciding which path to take is a completely subjective decision, and I would never advise someone on what to do for themselves, because risk tolerance is personal. But for us, knowing that we are in a relatively low-risk, debt-free position at all times is worth it.
That peace of mind and financial stability is exactly what gave us the courage to leave good jobs to take a 7-month tour of every National Park in the country. We would have felt compelled to stay at the office longer if our portfolio was carrying a bunch of extra risk. Since we were planning to live a semi-retired lifestyle, we felt like we should skew our asset allocation to look a little more like that of an actual retiree than a typical twenty-something.
It’s also worth noting that all of the above applies to the idea of early mortgage payoff as well as it does to paying cash for a house. When you make extra mortgage payments instead of investing that excess money into the stock market, you are de-leveraging your portfolio and reducing risk, most likely at the expense of long-term returns.
This same logic also applies just as well to any situation where you have the opportunity to take (or retain) any loan in order to keep more of your own money invested. If your investment returns significantly exceed the interest rate of the loan, you’ll come out ahead — but those investment returns are never a sure thing.
When you’re deciding what to do, be honest with yourself. Realize that taking a low-interest loan (or avoiding paying off an existing one) to put yourself in a leveraged investment position may actually make you richer over the long run. But also recognize that saving up and paying cash for things (or paying off your debts very quickly) gives your financial portfolio an amazingly stable base to rest on. Just remember the golden rule of investing: There is no such thing as a higher expected return without increased risk.
— Steven
* I realize that I’m totally misusing the words “revenue” and “profit” in all of this. Of course, foregone rent payments and unrealized capital gains aren’t actually “revenues,” but I hope you’ll agree with the underlying point I’m making here since I couldn’t think of a better word.
** It’s an awkward time to publish this article, amidst the massive stock market drop and the coronavirus panic. The stock market total return I quoted would have been more like 16% per year if I had published this article a month ago, but 11% is a much more realistic number for general use anyway, so I guess I’m not complaining.
*** We probably would have made mortgage payments out of our paychecks, not literally by selling stock every month. But remember, money that comes out of our paychecks is money we otherwise would have been able to invest, so it makes sense to think of these mortgage payments as “coming out of our stock investments” for the purpose of this analysis.
