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I have no mortgage on my house, which I believe is worth $550,000. Since interest rates are still pretty low, I'm considering borrowing all or part of the equity in my home to purchase investments. Do you think this would be a wise move?
-- Edward, Birmingham, Alabama
This one of those schemes that, in theory, seems to be a no-brainer, an all-gain-no-pain proposition. But to my way of thinking, that's exactly why you should be extremely wary about embarking on such an undertaking.
There is no investment strategy that eliminates all risk. There is always some way you can get manhandled in the investment markets. And sometimes the deals that seem the surest are the ones that come back to bite you in the derriere.
Why does it sound like a good deal?
First, let's talk about why borrowing against your home for investment capital seems so appealing. Even though mortgage rates have climbed somewhat this year, you should be able to get a 30-year fixed-rate loan at an interest rate of 6 percent or so.
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If you then invest the proceeds of that loan in a diversified portfolio of stocks and bonds -- say, 80 percent stocks and 20 percent bonds -- then it wouldn't be unreasonable for you to expect a long-term annualized return in the neighborhood of 8 to 9 percent. Let's say 8 percent. So, again theoretically, you would be paying 6 percent a year in interest and racking up 8 percent a year in earnings on your investments.
Of course, the analysis gets more complicated when you bring taxes into the equation. But for simplicity's sake, let's figure taxes are a wash, since you're likely taking a deduction for your mortgage interest (which lowers the true cost of your mortgage) and also paying taxes on your investment earnings (which lowers the true return on your investment).
Basically, you're skimming two percentage points a year for your trouble -- the difference between your borrowing costs and your investment earnings.
So what's the problem?
So what could possibly go wrong with this foolproof scheme? Well, for one thing, there's nothing that guarantees you'll get that 8 percent long-term return. I think the odds are good that you would. Very good, in fact.
But there have been long periods where a diversified portfolio along the lines I've suggested has earned less than 8 percent, and even less than 6 percent.
Even if your investments do earn 8 percent or more over the long run, there's nothing to say that they couldn't earn less, much less, over shorter periods, which could result in a short-term cash crunch for you.
If you had embarked on this scheme in 2000, for example, you would have posted returns of roughly -5.0 percent, -8 percent and -16 percent respectively in 2000, 2001 and 2002, based on returns for the broad stock and bond markets.
In the meantime, your mortgage expense would have been locked in at 6 percent, so you would have been paying out more than you were taking in. That means you would have had to rely on other income to make your mortgage payment.
Or you would have had to sell off part of your investment portfolio to pay the loan. If you choose that option, you would have less capital to participate in the market's rebound, meaning you would have to earn more than 8 percent annualized to maintain your two-percentage-point spread.
You could always end the arrangement, of course, by liquidating the portfolio and paying off your loan. And assuming your portfolio balance is higher than your loan balance you would come out ahead. But if you happened to run into a period of down years like the 2000-2003 period, it's possible your portfolio's value could be lower than the loan balance, and you'd have to come up with money from other sources to pay off the loan.
Invest with savings, not borrowed money
Call me a wimp, but I prefer to do my investing with money I've saved rather than money I've borrowed. (Yes, you could say that buying a home with a mortgage amounts to investing in real estate with borrowed money, but I see a major difference because the primary purpose is to live in the home, and my mortgage payment replaces what I would otherwise be paying in rent.)
I may be hit with losses either way. But if I'm using money I've saved, then I don't have to worry about coming up with cash to make a loan payment when my investments take a hit.
So, ultimately, I guess I'd say No, I don't think it's a wise move to borrow against your home for investment capital.
But if you're so tempted that you're going to ignore my advice, then I would at least hope that you limit your exposure by borrowing only a small amount. That way, if things go wrong, at least you're not jeopardizing your financial security.
Walter Updegrave is a senior editor at MONEY Magazine and is the author of "Investing for the Financially Challenged." He also answers viewers' questions on CNNfn's Money & Markets at 4:40 PM on Monday afternoons.
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