Should You Pay Cash When You Downsize? Here Are Three Scenarios

The proceeds from selling your current home have made it possible to pay cash for your retirement home, but should you skip the mortgage?

A man holds a stack of cash with a house in the background.
(Image credit: Getty Images)

I was an early COVID mover. I bought a newly renovated, but quite old, home in June 2020. About a month after moving in, we had water in the basement. The thing about water in the basement is that it tends to happen again and again until you fix the problem. After many trials and tribulations, we fixed the problem. In December of 2020, I got home one day to find water coming from the ceiling right inside the front door. I called an emergency plumber. After inspecting all of the plumbing, he told us that we had a cracked pipe … and that we should probably replace the faucets in the kitchen for efficiency purposes. That last piece of advice I could have done without. Just fix the pipe!

Prospective clients often come to me with “leaking pipe” problems. Things that are time-bound and important enough that they will cause damage elsewhere if not solved quickly and properly. Figuring out whether you should pay cash for a home falls into that category.

The spring housing season is heating up, and because you wanted to get ahead of it, you put a contract on a new condo. The proceeds from selling your home allow you the flexibility to decide whether you will pay cash or get a mortgage for your (single-level) dream (retirement) condo. Here are three scenarios to help you decide whether you should.

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1. If you’ll never need the equity from the house for retirement income, pay cash.

In other words, you have plenty of savings and you will never be reliant on the equity component. This really has to do with the current interest-rate environment. With mortgage rates hovering around 7%, you may be in a negative arbitrage situation. In English: The rate of return on what you invest in with the equity may end up being less than 7%, and you’d end up losing. Two years ago, with mortgage rates at 3%, the equation was flipped the other way.

If you have specific numbers you want to plug in to figure out whether you should pay cash, you can access a free version of the planning software we use: Obviously, if you move that mortgage rate up or down, it may have a significant impact on the outcome.

2. If the math is tight, take the mortgage (and pray for rates to drop).

You don’t have quite enough saved to maintain your current lifestyle and could use the cash cushion. You should probably at least inquire about financing. Current five-year adjustable mortgage rates are about 1 percentage point less than 30-year fixed rates, so it may make sense to take out the loan and watch for an opportunity to refinance when rates drop.

Paying cash for a home is like putting money into a piggy bank with an incredibly small slot. It may take drastic measures, like a hammer, to get the money out. In the case of home equity, that means a home equity loan, reverse mortgage or sale.

3. If you have a large gain, do some math before choosing to pay cash or take out a mortgage.

I know this seems like an uptown problem, but the reality is that many of the Baby Boomers who are downsizing have been in their homes for 30-plus years and will owe some money in taxes. That tax bill can come as a surprise.

Assuming you meet the requirements to qualify for the 121 exclusion, a married couple is able to avoid taxes on $500,000 in capital gain ($250,000 per person). If you know that you are going to have more than a $500,000 gain, you should have your CPA or financial planner calculate the tax due. This can end up being over 30% of the gain because it may move you into the top capital gains tax bracket from a federal perspective. Depending on where you reside, you may also owe state and local taxes.

The worst outcome here is that you pay cash and realize a year or two down the road that you overextended yourself and have to get creative. Once again, the best way to avoid this is to have a financial plan that clearly lays out what you can afford and how you should pay for it. But if you have a leaky pipe and are closing next week, the above guidelines should help you decide what makes the most sense.

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This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

Evan T. Beach, CFP®, AWMA®
President, Exit 59 Advisory

After graduating from the University of Delaware and Georgetown University, I pursued a career in financial planning. At age 26, I earned my CERTIFIED FINANCIAL PLANNER™ certification.  I also hold the IRS Enrolled Agent license, which allows for a unique approach to planning that can be beneficial to retirees and those selling their businesses, who are eager to minimize lifetime taxes and maximize income.