High mortgage rates complicate the case for paying cash for a home

• Key insight: When deciding how to finance a home purchase, clients need to consider more than whether they can afford the monthly mortgage payment and what the rate will be, advisors say.
• Expert quote: “There’s so much more than rate in the conversation. There’s balance sheet management … and what is the right thing to do, not just for your investments, not just for your emergency cash, not just for this singular home, but how is all of this working to your benefit? And debt is not always bad.” — Rachel Scholl, mortgage executive at Merrill Lynch

With mortgage rates exceeding 7%, paying cash for a home can look more attractive than borrowing. But for clients who would need to sell investments to fund that purchase, doing so could come at the cost of capital gains taxes, reduced liquidity and lost investment opportunities, advisors say.

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The better choice depends on clients’ tax situations, time horizons, risk tolerance and need for cash, and may involve a combination of cash and debt.

“It is more of a holistic conversation of looking at what the investments look like, where we’re getting the proceeds to buy the house with,” said Thomas Pontius, director of financial planning at Los Angeles-based registered investment advisor Kayne Anderson Rudnick Investment Management.

Ultimately, it’s about taking “a more hedged approach,” he said. If advisors can mitigate the tax costs of selling investments, clients may be better positioned to keep those assets invested and potentially earn returns that help offset the costs of borrowing. 

Some clients might also be able to get lower rates than current averages, based on their banking relationships or wealth levels, perhaps 5.5% or 6%, said Rachel Scholl, mortgage executive at Merrill Lynch.

Still, advisors may have to contend with elevated borrowing costs. Rich Arzaga, the Colorado Springs, Colorado-based founder and CEO of The Real Estate Whisperer, a registered investment advisor, said he anticipates interest rates will continue to rise. National Association of Realtors Chief Economist Lawrence Yun recently said 7% rates should be expected “as the new normal.” 

For clients who want to avoid selling investments but would prefer an alternative to a traditional mortgage, other borrowing options may be worth considering. One possibility is a securities-based line of credit, particularly if the property will be short-term or a second home.

“There’s so much more than rate in the conversation. There’s balance sheet management,” Scholl said. “And what is the right thing to do, not just for your investments, not just for your emergency cash, not just for this singular home, but how is all of this working to your benefit? And debt is not always bad, even in this interest rate environment, and there are different kinds of debt our clients have the ability to use in order to create capital and liquidity.”

Tax consequences

Selling investments in order to pay cash can eliminate the need for mortgage payments, but it can lead to tax implications that alter the financial-planning equation. For example, liquidating investments could trigger a big capital gains tax bill, said Jason Juhl, a partner and wealth advisor at Carson Wealth in West Des Moines, Iowa.

“Being able to afford something and determining the best way to pay for it are two different conversations,” he added.

Juhl raised the question of which investments clients would need to sell. Using a taxable account tends to be optimal, he said, because long-term capital gains (held for longer than one year) are generally taxed at rates ranging from 0% to 20%, whereas withdrawals from traditional IRAs or 401(k) accounts are generally taxed as ordinary income.

Clients can also split the difference by taking out a smaller mortgage than they otherwise would. Juhl said many clients are hedging by using 50% cash and 50% financing. Down the line, they may be able to recast the mortgage, which involves applying a lump-sum payment to the principal and asking the mortgage carrier to reamortize payments based on the lower principal balance.

“It is a way to be able to pay down that principal quicker and adjust your payment based on the new and lower principal balance,” Juhl added.

Risk and age-related factors

Life stage and risk tolerance are also part of the decision.

“What age are these clients at where they’re buying houses? Are they downsizing, or is this a home that they’re really trying to leverage up on because they need the space?” Pontius asked.

No matter the mortgage rate, clients heading into retirement might not want to hold sizable debtwhen they’re going into that phase of life.

“Liquidity is really valuable for our retirees, and that’s where it’s a balance between the return on sleep” and return on investment, said Juhl. “How do we help them lay their head down at night? Is that liquidating investments? Is that paying cash? Or is that carrying a mortgage? And what size mortgage would we carry?”

Interest-only loans, in which monthly payments cover interest but not principal, are a way to minimize costs, Pontius said.

Although advisors may not be involved directly in helping clients secure a mortgage, they can help clients learn how to shop around for better rates and incorporate decisions into broader financial planning discussions. Arzaga said advisors should use planning software to model different scenarios, including clients’ tax bases, investment cost bases and potential early withdrawal penalties or fees.