Reader Question: Should I Buy a House With Cash?

should a grad student buy a house with cash
One Afford Anything reader asks:

In my area, I can buy a quality house/duplex for $45,000 – $100,000.

My partner and I want to get a house with great rentability. We’ll live in it for 4 years while I finish graduate school, at which point we’ll move.

We hope to keep the place – as a rental property — indefinitely.

My question is: Are we better off buying a 100% cash purchase that will give us less rental income? Or are we better off financing a property that is more expensive, and will give us higher rental income?

Sincerely,
Confused with Cash

Here’s my reply:

Dear Confused:

You can’t look at investments in a vacuum. You need to frame the invest within the context of your life.

You’re about to enter a 4-year graduate school program. That means you won’t be earning much income, and you’ll be spending a lot of your time on non-income-producing work.

Given your grad-student status, I’d make an all-cash purchase right now.

After you graduate and you and your partner are both working full-time, you can think about increasing your leverage. But while you’re in school, stick with the option that will free your mental space and maximize your flexibility.

That said, let me add two more points:

#1: Cash Reserves

I don’t know how much money you have set aside for emergencies – such as car repairs, home repairs, and covering your cost-of-living if you can’t find work. I’m assuming that you already have decent reserves built.

Building a cash reserve comes first, before everything else.

If you have to take out a very small mortgage (e.g. plunk down an 80 percent down payment and finance a small piece of the house) for the sake of preserving your emergency fund, go ahead and do it. It’s more important to have a strong emergency fund than it is to be mortgage-free but have $0 in cash reserves.

Why? Let’s say that you’re mortgage-free, but you have zero savings. Suddenly, your heater breaks. In the middle of winter. In Minnesota.

Suddenly, you’re on-the-hook for paying for a very expensive (and urgent) repair. If you don’t have cash reserves, you’ll be forced to charge it on a credit card — with a double-digit interest rate. Yikes!

Feel free to take out a mortgage in order to protect your cash reserves. Think of your mortgage as a “cheap insurance” policy that will protect you from sliding into credit card debt.

Speaking of which …

#2: High-Interest Debt

Since we’re chatting about buying a house in cash, I’m assuming that you don’t have any high-interest debt, such as a credit card. If you have a dime of debt, I’m assuming it’s ultra-low-interest (e.g. lower than a typical mortgage).

If that assumption is wrong … friggin’ pay off your debt. That’s Priority Number One. Build a teeny-tiny cash reserve (about $1,000) and then devote every dime to paying off your high-interest debt.

Assuming you’re debt-free and you have solid cash reserves, shoot for the all-cash rental property purchase. And enjoy grad school!

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12 Responses to “Reader Question: Should I Buy a House With Cash?”

  1. Deia @ Nomad Wallet
    02. Feb, 2014 at 7:07 pm #

    I agree with Paula. If you have a big chunk of cash now and will be earning less income, it’s a good idea to purchase the property with cash.

    You might also have more negotiating power if you buy it with cash because you can do a quick closing. The seller doesn’t have to worry about you not qualifying for a mortgage and backing out of the deal.

    I buy rental properties in cash. Sometimes a rental sits empty for a couple of months and it’s a big relief that I don’t have to worry about not having rent income to cover the mortgage payments. Also, some of them are really cheap (my latest one was $22,000).

  2. Mrs. PoP
    02. Feb, 2014 at 7:24 pm #

    The only other thing I would make sure to consider is how comfortable you would be renting the house from afar. Depending what type of grad program you’re in, or where you are in it, tying yourself to a location could be a detriment. The last thing you want is a place you’re not comfortable handing over to a property manager and simultaneously wanting to leave the area (either for school or future career moves – since if you’re headed to academia there may be several physical moves before you end up with a TT job).

    • Afford Anything
      03. Feb, 2014 at 12:09 pm #

      Awesome point, Mrs. Pop! Avoid location-dependence. I’m comfortable handing the keys to a great property manager, but not everyone shares that same tolerance. (It’s helpful to work with a property manager while you’re still in-town, so that you can learn to trust that particular person … then, when you’re ready to leave town, you’ve already built a relationship with someone.)

  3. Kathy
    03. Feb, 2014 at 9:20 am #

    Your advice is spot on. If there is no emergency fund, it is really hard to get cash out of a house unless you attach a HELOC to it which kind of defeats the purpose of buying with cash. And keep in mind the difficulty that having a rental property far from where you live can create. Even with a property manager, you still have to keep up on the investment.

  4. Done by Forty
    03. Feb, 2014 at 9:53 am #

    With that sort of pricing, I can see how buying in cash might put him ahead of renting. I’m a fan of paid off real estate, and in this grad student’s situation I think you’ve given some sound advice in avoiding leverage at this point.

  5. Anne @ Unique Gifter
    03. Feb, 2014 at 12:42 pm #

    I’m with what Paula said, make sure you have reasonable cash reserves left and buy the one straight out in cash. Another option that I see is if the more expensive house is something you can start renting out immediately via shared accommodation, so that you have a history as a landlord prior to moving on. If that’s the plan, you’ll still need the cash flow to make it make sense though.

  6. Jonathan
    03. Feb, 2014 at 6:06 pm #

    I think everyone missed the point of the question a bit. The reader is not asking if she should purchase in cash or with a mortgage – she’s asking if she should purchase the house she can afford outright (in cash) or should she purchase the more expensive house that she can’t afford outright with a mortgage, as it would provide more rental income.

    The answer lies more in the details that she doesn’t provide (and perhaps doesn’t know). First of all, if she’s looking for the most rentable property, what types of property are in demand in her area? Cheap duplexes, nicer single family homes, other..?

    Second of all, identify market rent rates and compare them to rental prices to determine the price-to-rent ratio. If the $45,000 place rents for $600 a month, then gross annual rents will equal 16% of the purchase price. If the $90,000 place rents for $900 a month, then gross rents are only 12% of the purchase price.

    Third, look at the financing options. Let’s assume that the $90,000 place actually rents at double the $45,000 place, so $1,200 a month. If you get a 70% mortgage at 5% interest for 30 years, you’ll put $27,000 down and get $862 in gross rents each month (after paying the $338 mortgage). This makes the gross return on the $27,000 down payment a healthy 38%, much better than the 16%/$600 you’d be getting on the $45,000 purchase.

    Obviously there are more variables, such as maintenance, vacancy, property taxes, potential appreciation (the more expensive place may have more room to increase in value). So the answer to the question really is, find someone knowledgeable about real estate investment and your local property market and have them talk you through the options.

    • Afford Anything
      05. Feb, 2014 at 9:23 am #

      @Jonathan — Great points, but I should add: Even if the gross return on a financed property is better than the return on a cash property, that doesn’t mean she should take it.

      Returns don’t happen in a vacuum; they happen within the context of risk. (Stock-traders often talk about a notion called “risk-adjusted returns,” which refers to the ROI on an investment relative to the amount of risk that the investor accepted in order to achieve it. Earning 7 percent on a Treasury bond is a “higher risk-adjusted return” than earning that same 7 percent on Facebook stock).

      Debt is the ultimate form of risk, since her investment is leveraged. She stands to lose more than just her principal; she stands to lose her principal PLUS the money she borrowed.

      If this reader was working full-time and had other sources of income that he/she could tap in order to temporarily patch any cash-flow problems, I’d be much more in-favor of considering leverage. But since the reader will be in grad school for four years, paying tuition/student fees and devoting the bulk of his/her time to an all-consuming, non-income-producing type of work, I think this reader should stick with making a cash purchase for the moment. We can revisit this question after he/she graduates.

  7. Money Saving
    07. Feb, 2014 at 11:03 am #

    I guess I’m kinda in the minority, but I’d mortgage the house (3% – 4% rates), keep a small emergency fund, and invest the rest in market index funds (8% – 12% returns in the long run).

    This will provide you the best return in the long run if you’re planning to own the house into perpetuity. Maybe I’m over-simplifying things…

  8. I’m glad to see I’m joining a lively debate here. In response to the person’s question it would seem that they need to asses their overall risk in having a big chunk of money tied up in the property. If paying in cash means they won’t have very much money on hand (as you rightfully asked) in the case of an emergency I would say that it would be wise to stay away. If they have a well stocked emergency fund then I say go for the cash purchase. Also it would be super cool to be able to tell people “I paid cash for my house”

  9. EL @Moneywatch101
    17. Mar, 2014 at 1:51 pm #

    I agree if you don’t have debt pay for it with cash. This will allow you to live mortgage free while using the income to pay your tuition.

  10. Steven J Fromm
    27. Mar, 2014 at 8:34 am #

    I sort of agree but liquidity and risk need to be assessed based on the specifics of your situation. You must stay liquid here. What if you have a vacancy during the term or as stated you have major repairs? Also, if you put all your money in this property what happens if the property goes down in value or some other unforeseen event occurs. Now all your cash is tied up in a bad investment. Diversify and minimize risk should be paramount considerations.

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