You will often hear real estate agents and investors talk about "free and clear" real estate, but free and clear is also an aspiration of many homeowners. Free and clear means there are no encumbrances secured to the property, such as a lien or mortgage.
- Most home sales today require a former mortgage to be fully paid off before the new buyer takes on a new loan.
- Paying cash for a home is one way to buy free and clear, but the tradeoff is that you lose the ability to use leverage.
- Owning a home free and clear can offer a sense of security, but there will still be costs like maintenance, taxes, and insurance.
How Free and Clear Can Let Seller Finance
If you have a 30-year fixed-rate mortgage and make the same monthly payment every month for 30 years, at the end of 30 years, you will own your home free and clear. Free and clear means if you were to sell the home and wanted to make owner financing available for a new buyer, you would have no underlying lenders who could prevent that choice.
Free and clear is the easiest way to provide owner financing when selling if a buyer cannot or does not want to obtain a loan. The problem with most owner-financed transactions is usually that the property already has at least one loan. Almost every existing mortgage today contains an alienation clause that calls for acceleration of the loan in the event the property is sold. This clause is often referred to as a "due on sale" clause.
In the 1970s and early 1980s, many mortgages did not contain verbiage that prevented a subject to transaction (not to be confused with a loan assumption). This meant sellers could offer owner financing and let the buyer take over payments on an existing loan without either party getting into trouble or breaking any laws. Today, these types of transactions are rare. Lenders today demand to be paid off.
Most lenders will exercise the option to call a loan due and payable if interest rates are rising. That's because they want their money back so they can lend it out again at a higher interest rate.
Leverage vs. Paying Cash for a Home
Another way to obtain a free and clear home is to pay cash for the home. Rather than pay a mortgage payment every month, some home buyers prefer to buy it outright by handing over a lump sum cash payment. It's a good investment to pay cash for a home, but it also prevents a buyer from buying a home and using leverage.
Say you have $100,000 in cash and want to buy a home for $100,000. If you used leverage, you could put down $25,000 and buy four homes, using 80% loan-to-value mortgages. When you choose to go clear and free and buy one home for $100,000, you owe nothing—except property taxes.
The Benefits of Free and Clear
Owning a home outright is a good feeling for many people. It is emotional security that the home belongs to the owner 100%. It is not 100% protection, though. For example, it does not mean a home cannot be seized under eminent domain by the government. It does not mean the home can't be wiped out by a hurricane or flood.
You will also hear the term "clear" in reference to the title. Assuming there is no cloud on title and you received a title insurance policy when you bought the home, you most likely enjoy clear title to the home. However, if you pay a mortgage on that home, then the home itself is not free and clear.
Also, though you may be free and clear from making mortgage payments, you still need to pay for such things as homeowner's insurance, property taxes, utilities, and general maintenance.
Pay attention to the tax benefits of paying a mortgage. Until recently the cap on interest deductions was $1 million, but homes purchased after Dec. 15, 2017, are limited to an interest cap of $750,000 under the 2017 Tax Cuts and Jobs Act.
Buying a Vacation Home Free and Clear
A family made the decision to finance a vacation home in Hawaii. When property taxes escalated due to non-residency status, the increase affected monthly cash flow. A solution to the situation was to refinance the primary residence, which had a 15-year loan, paid down over 10 years with 5 years remaining. The family refinanced to a 30-year loan with the same monthly payment, and used the proceeds to pay off the home in Hawaii, free and clear.