When to pay cash and when to finance

Dorie Fain
Dorie Fain is the founder and CEO of &Wealth, a boutique financial advisory firm dedicated to helping women who are recreating their lives, with offices in New York City and Baltimore.

Published 7/9/2017 in The Maryland Daily Record 

When considering a new home purchase, many of our clients debate the merits of paying all cash or financing a portion of their purchase with a mortgage. For clients who are fortunate enough to have the options, there are benefits to both scenarios that depend on each person’s situation and what will make the choice right for them.

Before advising a client as to which path to take, we start with the CPA for our client to understand the full picture of tax benefits of having a mortgage. In some cases, there are meaningful tax advantages to being able to write off the mortgage interest deduction based on the income tax bracket of the client and the amount of interest paid each year for the mortgage. The higher federal income tax brackets yield the greatest benefits. This is the good news and the bad news: The good news in that you earn enough money to be in the highest tax bracket and garner the greatest tax savings on the interest paid on your mortgage; the bad news in that you are paying the larger percentage of income taxes relative to those who earn less and pay a lower percentage.

Once we confirm that the CPA has provided a tax projection to weigh the true benefit of the actual tax savings, we look to the terms of the loan and how this fits with the client’s overall financial plan and comfort level. As a starting point, we consider the actual rate of interest being charged to have the mortgage loan. As an example, an interest rate of 4 percent on an after-tax basis in highest marginal federal income tax bracket would be the equivalent of a true rate of return of 2.41 percent. The math looks like this: 4 percent mortgage rate x 39.6 percent marginal federal tax rate (The percentage savings off the actual mortgage rate) = 2.41 percent after tax rate.

When we consider the term of the mortgage loan, typically 30 years, we factor the amount of the loan, as an example $200k, and apply a rate of 2.41 percent growth on these funds and compare this to the alternative of investing $200k over a 30-year period to see where the funds would end up better off in the long run. Over the historical performance of the stock market, there has been a clear advantage to investing the funds in stocks over the long-term mortgage rate that would be earned.

More than math

However, the simple math isn’t the only consideration. There are not many other meaningful ways to find tax savings like a mortgage interest deduction. Often CPAs advise their clients who are renters to become homeowners for this very reason. So, the question is how much to borrow and how much cash to use for the home purchase to strike the balance between the available cash for purchase versus investment, tax advantages, the client’s comfort level with debt depending on her stage of life.

Another key consideration is your source of income and the stability of this income over time. Many of our clients receive alimony payments that can be fixed for a certain period and decline over time, ultimately reaching an end date. Sometimes there are factors that could affect alimony payments and that would also create a change in the overall impact of the tax benefits of the mortgage interest deduction. As income goes down the tax benefits go down, though ultimately less taxes are due, which is in line with earning less income. This could also be true as someone is nearing retirement and considering a move to a new home. Earned/taxable income may decline, making the tax benefit of a mortgage less favorable.

Ultimately the magic answer really has to do with the client’s preferences and comfort level with having debt. Each person needs to assess her own sense of comfortable with having debt. Often our clients were raised with the financial mindset of being debt free as reflecting financial responsibility and sound decision-making. For many, this is a life aspiration. Despite the tax and financial benefits that may come with having this healthy type of debt, people must weigh their own peace of mind with owing money and making monthly payments over time. While there may be a “right” financial answer, this needs to be balanced with what feels right to anyone facing this process and decision.

Dorie Fain, founder and CEO of &Wealth