Borrowers Often Underestimate The Importance Of Liquidity
Especially when times are good.
When rates are relatively low (under 8%), we always recommend using financing (obtaining a mortgage) to buy real estate, even if borrowers have ample cash.
Similarly, we usually advise borrowers (who want lower 15-year rates) to take 30-year mortgages over 15-year mortgages. Even though borrowers can afford the higher 15-year payment, because the lower 30-year payment offers them more flexibility.
Why Borrowers Should Value Liquidity More
There are several reasons why borrowers should value liquidity more.
1. Job Loss, Major Illness, Injury, Legal Troubles, Recessions. People often forget how quickly fortunes can turn (especially those of us in sales), and how important cash is when income dries up. This in particular is the case when the economy turns and financial instruments and hard assets drop in value and become difficult to sell. An abundance of cash during unexpected hard times often means the difference between bankruptcy and muddling through.
2. Ability to Buy Distressed Assets. When the economy turns and asset prices tank, there are often tremendous bargains to be had for anyone with even a little cash. After the mortgage meltdown, for example, one of our clients purchased eight rental properties for around $100,000 each. He was out of pocket less than $250,000 for all of those purchases, and all of the properties cash-flowed from the start. In addition, they now are all are worth close to $300,000 each. I watched many other clients do the same thing in the stock market after both the dotcom crash and the 2008 meltdown.
3. Investment Returns Exceed After Tax Cost of Mortgage. This does not apply to everyone of course, but many borrowers can often invest money that they do not put into their home and earn a return that exceeds the cost of their mortgage, especially after tax benefits are taken into account.
Example: Borrowers A and B both have $250,000. “A” puts down 50% on a $500,000 house; “B” puts down 20% and invests the $150,000 he saves. In the long run, borrower B will have a much higher net worth and more liquidity along the way if his investment yield exceeds his rate by 2% or more (not difficult over the long term).
Sign up to receive our blog daily