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I recently starting looking into purchasing a home and talked to a realtor if he knew how much any of the homes in the area went for. He said that a home across the street was purchased for 700k in cash. After the tenants moved in, they turned around and "got a large loan on the house to buy stock". I'm guessing this was a reverse mortgage.

My question is this. This transaction doesn't seem to make sense (buying a home and then borrow money on the equity of the home when the tenants could have just bought stock to begin with). Am I missing something?

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I think you're missing a couple of things.

First - why do you think its a reverse mortgage? More likely than not its a regular mortgage - home equity loan. If so, if they expect the stock market to rise significantly more than the amount of interest they pay on the loan - then its a totally sensible course of action.

Second - the purchase in cash only to take out a loan later can definitely be a sensible way to do things. For example, if the seller wants to close fast, or if there are competing offers where not having a contingency is the tipping point. Another reason might be purchasing in an entity name (for example holding the title as an LLC), and in this case it is easier to get a loan if you already have the house, since the banks see the owner's actual commitment and not just promises.

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Good point. I was looking for a house in a very hot market where cash is king and a tool to win a bid for a house. It's likely they paid cash to win out other people bidding on the home. Also, I wasn't aware of getting a regular mortgage for a paid-for home which is why I thought it they got a reverse mortgage. Thanks for the great answer! –  arcdegree Feb 13 '13 at 6:19
    
@littleadv - getting a mortgage like this, after the fact, may jeopardize the deduction of interest. It might be limited to first 100k of loan principal, the rest being considered investment interest. –  JoeTaxpayer Feb 13 '13 at 13:21
    
@JoeTaxpayer But isn't interest paid on money borrowed to make investments deductible on a separate line of Schedule A, though the amount deducted cannot exceed the actual total investment income? –  Dilip Sarwate Feb 13 '13 at 13:52
    
"the rest considered investment interest" yes. You're right. Additionally, it cannot be deducted at all if used to invest in tax free munis. –  JoeTaxpayer Feb 13 '13 at 13:57
    
@Joe that's true, I initially wrote a whole paragraph about that and the discussion you just had with Dillip, but then decided its irrelevant to the question and took it out. –  littleadv Feb 13 '13 at 18:15

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