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In most cases of purchases the general advice is to save the money and then make the purchase. Paying cash for a car is recommended over paying credit for example. For a house, getting a mortgage is recommended.

Is this because a house is so expensive, saving is not practical? Is it because the house is expected to appreciate in value? Then isn't a mortgage really just an option to own a property that you buy with borrowed money and you're betting that the house's price will increase?

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    Once you have bought a house, you don't have to pay rent anymore. For most other goods the alternative to buying is abstinence, not renting them. – CodesInChaos Sep 13 '15 at 10:47
  • This question is a companion question to this one: Is a car loan bad debt? – Ben Miller Sep 13 '15 at 12:23
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    leverage. thats why – CQM Sep 13 '15 at 16:10
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    People borrow to buy houses because they either don't want to wait until they have saved the full value of a house, or because they have that but not enough more to reasonably safely live on after buying a house for cash ("house rich, cash poor" is a rather illiquid position to be in), or because they believe they can get enough gains from their investments to more than cover the cost of the loan, or some combination of these. – keshlam Sep 13 '15 at 17:02
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In most cases of purchases the general advice is to save the money and then make the purchase. Paying cash for a car is recommended over paying credit for example. For a house, getting a mortgage is recommended.

Says who? These rules of thumb hide the actual equations behind them; they should be understood as heuristics, not as the word of god.

The Basics

The basic idea is, if you pay for something upfront, you pay some fixed cost, call it X, where as with a loan you need to pay interest payments on X, say %I, as well as at least fixed payments P at timeframe T, resulting in some long term payment IX.

Your Assumption

To some, this obviously means upfront payments are better than interest payments, as by the time the loan is paid off, you will have paid more than X. This is a good rule of thumb (like Newtonian's equations) at low X, high %I, and moderate T, because all of that serves to make the end result IX > X.

Counter Examples

Are there circumstances where the opposite is true? Here's a simple but contrived one: you don't pay the full timeframe. Suppose you die, declare bankruptcy, move to another country, or any other event that reduces T in such a way that XI is less than X. This actually is a big concern for older debtors or those who contract terminal illnesses, as you can't squeeze those payments out of the dead. This is basically manipulating the whole concept.

Let's try a less contrived example: suppose you can get a return higher than %I. I can currently get a loan at around %3 due to good credit, but index funds in the long run tend to pay %4-%5. Taking a loan and investing it may pay off, and would be better than waiting to have the money, even in some less than ideal markets. This is basically manipulating T to deal with IX.

Even less contrived and very real world, suppose you know your cash flow will increase soon; a promotion, an inheritance, a good market return. It may be better to take the loan now, enjoy whatever product you get until that cash flows in, then pay it all off at once; the enjoyment of the product will make the slight additional interest worth it. This isn't so much manipulating any part of the equation, it's just you have different goals than the loan.

Home Loan Analysis

For long term mortgages, X is high, usually higher than a few years pay; it would be a large burden to save that money for most people.

%I is also typically fairly low; P is directly related to %I, and the bank can't afford to raise payments too much, or people will rent instead, meaning P needs to be affordable. This does not apply in very expensive areas, which is why cities are often mostly renters.

T is also extremely long; usually mortgages are for 15 or 30 years, though 10 year options are available. Even with these shorter terms, it's basically the longest term loan a human will ever take. This long term means there is plenty of time for the market to have a fluctuation and raise the investments current price above the remainder of the loan and interest accrued, allowing you to sell at a profit.

As well, consider the opportunity cost; while saving money for a home, you still need a place to live. This additional cost is comparable to mortgage payments, meaning X has a hidden constant; the cost of renting. Often X + R > IX, making taking a loan a better choice than saving up.

Conclusion

"The general advice" is a good heuristic for most common human payments; we have relatively long life spans compared to most common payments, and the opportunity cost of not having most goods is relatively low.

However, certain things have a high opportunity cost; if you can't talk to HR, you can't apply for jobs (phone), if you can't get to work, you can't eat (car), and if you have no where to live, it's hard to keep a job (house). For things with high opportunity costs, the interest payments are more than worth it.

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    Perhaps off-topic, but I really like that you restrict this statement by species: "the longest term loan a human will ever take." – Dave Sep 24 '15 at 23:46
  • "Taking a loan and investing it may pay off, and would be better than waiting to have the money, even in some less than ideal markets" But, if you take out a loan to pay for a house and then invest it instead, that means you don't have any money to buy the house with, correct? Or by "investing" did you mean "investing in buying a house"? – TylerH Aug 4 '16 at 20:51
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First, who is saying that it is a better option? In general it is best to pay cash for things when you can. I think the reality is that for most people owning a house would be very difficult without some sort of financing.

That said, one argument for financing a house these days even if you could afford to pay cash is that the interest rates are very low. For a 30-year fixed loan you can borrow money under 4.5% APR with decent credit. If you are willing to accept even a little risk you could almost certainly invest that same money and get a return higher than 4.5%. With the US mortgage interest tax deduction the numbers are even more favorable for financing.

Those rates look even more attractive when you consider you are paying for the house with today's dollars and paying back the loan with dollars from up to 30 years in the future, which will be worth much less.

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    It has nothing to do with "expected to appreciate". Taking a low-rate mortgage when you don't absolutely have to can be a relatively low-risk opportunity to do some leveraged investing, as noted in John's answer... but the house you are living in is housing, not investment; trying to consider it both at once leads to things like the recent foreclosure storm. – keshlam Sep 13 '15 at 3:07
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    Interesting opinion. You're right that it really depends on how you see the purchase. If you are really buying a house to live in and nothing more, then yes it's not an investment. I do think that "expected to appreciate" has very much to do with it because people with underwater mortgages aren't just happily continuing to pay every month and patting themselves on that back that even though their house is worth 30% of what they paid, they sure are glad it's "not an investment". – oceanus Sep 13 '15 at 3:29
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    If you understand that it isn't an investment, being under water is absolutely irrelevant until/unless you have to sell it. (Well, almost. It may force you to pay for PMI.) And if you understand that it isn't an investment, you will be tremendously less likely to overbuy/overpay under the assumption that you are certain to sell it for a profit; that assumption is the major cause of underwater situations. – keshlam Sep 13 '15 at 3:44
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    "which will be worth much less" -- careful now. The low rate of interest you're paying is strongly dependent on the current low rate of inflation. So the thing that causes "dollars in 30 years will be worth much less" to be true, is also liable to cause "the interest rates are very low" to become less true. Even 1% inflation compounded over 30 years is a good chunk off the real value of the loan, but the current US CPI is 0.2%. In general unless you make a good decision on a fixed rate, any benefit you get from inflation is something you've already paid for in the interest rate. – Steve Jessop Sep 13 '15 at 11:24
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    And if your house blows away, you still own the land, which in many places is the larger part of the value. – keshlam Jul 16 '16 at 23:11
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First, as others have commented, the idea that getting a mortgage to buy a house is always a good idea is false. It depends on a number of factors including the current interest rate, what you think the future interest rate will do over the life of your mortgage, the relative cost of renting vs. buying, and how long you would stay in the house that you bought.

To the extent that a mortgage for a house is more often recommended than buying other goods on credit, it is for these reasons:

  1. In the US at least, there is a tax deduction for mortgage interest but not for other types of interest paid. This means that to some extent you're choosing between paying money to the IRS or to the bank. It's a deduction not a credit, so this is not a $1-for-$1 trade, but in a lot of cases it can help tip the balance toward taking the loan.
  2. Over recent history especially, the mortgage interest rate has been low. Between inflation, which will tend to devalue the true cost of your mortgage, and the better-than-even odds that bank interest rates on savings will go up over the term of a 30 yr mortgage, you have some factors in your favor that you won't have on a higher-rate loan / credit card. (Inflation and increase saving interest rates won't help you enough on a credit card debt with 30% interest.)
  3. As you note, there's some expectation / hope that a home will go up in value over time, so it has investment value. Many other goods (but not all) that you might buy on credit will devalue.

Except for #1 above, you could and can find other situations where taking a loan makes more sense than buying in cash. This more true if you have the resources and the skill to invest money at a rate that beats the interest rate you pay to the creditor. The general advice not to try this rests in the fact that most people don't have the resources or the skill to actually make this pay off, especially on high-interest rate loans or over short time periods.

  • Another major financial reason for getting a mortgage to buy a home is when it is cheaper (including all relevant factors like maintenance, etc.) compared with renting. Depending on the market you're in, this may or may not be true, for a given length of time. I don't like the phrase "throwing away money on rent", but sometimes yes, rent payments due exceed the true cost of ownership even including the risk involved. – Grade 'Eh' Bacon Aug 4 '16 at 13:55
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You can explore the scenarios in which it is better to rent or to buy using this application:

http://demonstrations.wolfram.com/BuyOrRentInvestmentReturnCalculator/

In the possibly unlikely scenario shown below, at the term of the mortgage (20 years) the tenant and the buyer have practically the same return on investment. At this point the tenant's savings would be sufficient to buy a house equivalent to the buyer's, and this would be the advisable course of action (based on the figures alone).

enter image description here

enter image description here

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    @Grade'Eh'Bacon Actually the application specifically does not ignore the impact of saving money while renting. As it says at the bottom, "The comparison assumes the use of equivalent capital" - so any difference between the buyer's mortgage and the tenant's rent is invested by the tenant at the deposit rate. As for point A, the down payment, for simplicity the application models a 100% mortgage, so there is no down payment. – Chris Degnen Aug 4 '16 at 14:31
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    @Grade'Eh'Bacon I have added a modeling details panel to my answer. – Chris Degnen Aug 4 '16 at 14:58

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protected by Chris W. Rea Aug 3 '16 at 22:19

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