Mortgage Rates Are Going Up, but You Still Shouldn't Buy a Home in Cash. Here's Why

If you're thinking about paying cash for a home, read this first.

Mortgage rates are much higher today than they were last year. Despite a recent drop in rates, the average interest rate for a 30-year fixed-rate mortgage is still well above 5%. This is disappointing for buyers who missed out on rates that were below 3% just last year.

But while it will definitely cost you more to borrow to buy a home now, taking out a loan is still the best move for most people -- even those who could afford to pay cash for a property.

If you're thinking about paying out-of-pocket instead of taking out a loan, here are a few big reasons why you may want to reconsider making that move.

You can still earn a better rate of return elsewhere

Although mortgage rates are above 5% now, and that seems high relative to what home loans have been costing recently, the reality is that this is still a pretty low rate. The average annual rate in both 2007 and 2008 was above 6%, and during the 1980s and 1990s, people regularly paid above 10% for a home loan.

A rate of 5% isn't too bad when looking at the big picture -- and especially when comparing it to the returns you could earn elsewhere.

The S&P 500, for example, is one of the safest investments out there for patient long-term investors. It tracks a financial index made up of 500 large U.S. companies so it enables you to invest in big business in America. Historically, it has produced average annual returns of about 10%.

If you pay cash for a house, the return on investment (ROI) you get is the interest you save on the loan it would’ve taken to buy the same property. If you have a choice of a 5% rate of return or a 10% rate of return, why would you choose to pay cash for a home and accept the fact your money will earn half of what it could?

When figuring out your rate of return, you also have to remember that you can take a deduction for interest on up to $750,000 in mortgage debt if you itemize when you file your taxes. This makes borrowing even cheaper. And your rate is fixed over time, so your payments effectively get cheaper as you pay back your loan with money that has less value due to inflation.

Tying up so much cash just doesn't make sense for most people

Aside from the fact that you can still borrow for a reasonable rate, it typically also does not make sense to tie up hundreds of thousands of dollars in a home, which is not a liquid asset. If you invest in the stock market and you need the money back, you can easily sell your assets immediately and without large transaction costs. The same is not true for a house.

It doesn't make sense to deprive yourself of flexibility when you can borrow at a rate that is good by historical standards and when you can invest elsewhere, earn a better rate of return, and have easier access to your money. Instead, it's generally better to shop around to get the lowest rate available now and to refinance later if rates happen to go down in the future.