Some wealthy individuals are fortunate enough to be in the position of being able to fund a home purchase without taking out a mortgage. However, paying for a home with cash instead of taking out a mortgage can be poor investment execution in a great asset for at least three good reasons.

First, the U.S. federal tax code makes mortgage financing exceptionally cheaper than the interest rate shown on your mortgage statement. As a result, you can almost always find better ways to use your cash than using it to avoid a mortgage. Second, while on the surface paying all cash for a house seems like a conservative option, in reality it can be a risky strategy, as it may be difficult to access your money quickly should a financial disaster create the need. Finally, by limiting your home purchase to the amount of cash you have to invest in your home, you assume all the risks of equity ownership without the benefit of leverage, which allows you to gain a more significant return on equity on terms of your home’s appreciation.

How to profit from your cash

The most important argument in favor of mortgage financing is the mortgage interest tax deduction allowable on both federal and Hawaii state tax codes. The principle benefit to the taxpayer is that the interest from mortgages on your primary residence (and second home, if applicable) has an aggregate deduction limit for mortgages up to $1,000,000, or a combination of $1,000,000 in mortgages and $100,000 in home equity loans, for a total of up to $1.1 million.

For individuals in the highest federal tax bracket of 39.6%, who would also be in the 11% Hawaii state tax bracket, a mortgage interest rate of 3.5% pre-tax equates to an effective 1.88% mortgage interest rate after factoring in the mortgage interest deduction. This calculation is done by taking Hawaii’s top income tax rate of 11% and adding this to the federal rate (and backing out 39.6% of 11% because state taxes are deductible on a federal return) giving a marginal tax rate of 46.2%.

Put another way, at the top tax brackets every penny invested in a house in excess of the down payment necessary to obtain a mortgage earns 1.88% after tax in Hawaii. A more profitable alternative would be to purchase something like high quality, tax-exempt municipal bonds, which currently yield about 3.00% (also on an after-tax basis).

To quantify this, suppose you are a high-earning Hawaii resident, have $1.25 million in cash and are buying a house worth $1.25 million. Strategy A is to pay for the home in all cash. Strategy B is to put $250,000 down, take out a $1 million mortgage to finance the home purchase, and invest the remaining $1 million in municipal bonds. At the end of a year, Strategy B would cost $31,828 in gross mortgage interest, generate $15,411 in income tax savings and yield $30,000 in tax-exempt interest income for a profit of $13,583 in the first year. This example looks at just municipal bonds as the only alternative investment for simplicity’s sake only. A diversified portfolio consisting of multiple asset classes is better on a risk-adjusted basis than a 100% investment in any one asset class.

Liquidity and Risk

Real estate is not liquid. We never know if we’ll be able to sell the home quickly at an advantageous price at any given time, for example, during a recession. Also, if you lose your job or suffer a business setback are the times when you may need to access the equity tied in your home, but they are also the times when banks are least willing to lend. Liquid financial assets, on the other hand, can more easily be tapped as needed.

The mortgage interest deduction is not a secret, but the idea that mortgage financing is a more profitable option even with a conservative portfolio can surprise many. It must be mentioned that the value of your investments will rise and fall. Therefore in these situations I recommend a conservative diversified portfolio with a long term time horizon focusing on yield to minimize value fluctuations even for those with a high risk tolerance.