Bad advice
I'm thinking of paying off my mortgage early. But an adviser has suggested taking out a home equity loan on my house and investing the proceeds in an insurance policy. Our expert advises not.
By Walter Updegrave, MONEY Magazine senior editor

NEW YORK (CNNMoney.com) - I plan to retire in three years and expect to be able to live well from my retirement plan and other investments. I'm also thinking of paying off my mortgage early so I won't have a large house payment in retirement. But an adviser has suggested that I instead take out a home equity loan on my house and invest the loan proceeds in an insurance policy, which he says will accumulate cash value tax-free. Can you give a second opinion on this advice?

- Mike Quatrini, El Paso, Texas

Yes, here's my second opinion: don't do it.

The plan your adviser suggests would work out great for him since he'll probably get a nice big fat commission on the sale of the insurance policy. Things may not turn out so nicely for you, however.

In fact, I believe you would be embarking on a plan that entails quite a bit of risk and that you may be seriously jeopardizing the later years of your retirement, just when you would have fewer options to repair the damage.

Too risky later in your retirement

Your adviser's recommendation is based on the fact that when a life insurance policy has an investment component that builds cash value, you can tap the policy's cash value by borrowing against it. Since loan proceeds aren't taxed, many insurance agents and financial advisers tout this strategy of borrowing against the policy as a way to generate "tax free" return or get "tax-free" cash in retirement.

There's one big risk you should know about, though. This entire strategy hinges on the assumption that your policy's loan balance - your borrowings plus interest - would remain outstanding the rest of your life. When you die, the loan would be repaid from the policy's death benefit.

But if your policy lapses for any reason - perhaps you can't afford the premium payment late in retirement - then most of what you've borrowed would be considered taxable income. So, for example, if you started borrowing against the policy at, say, 65 and the policy lapsed when you hit 85, you could be faced with a huge tax bill just when you're least prepared to handle it.

In your case, you're taking on even more risk since you are not only borrowing against the insurance policy, you're also borrowing against your home to come up with the cash to buy the insurance.

I'm sure your adviser can provide all sorts of projections that will make this scheme seem like a no-brainer. But make no mistake: this isn't a risk-free proposition, and the most dangerous point in this strategy isn't early in retirement, but much later on when you've got huge loans outstanding.

Why take on the risk at this point?

So my question is this: if your retirement plan and investments are in good shape, why in the world should you even consider getting involved in an arrangement that introduces a new element of risk into your retirement? Retirement is a time to enjoy life, to do the things you couldn't do during your career. It's not a time to worry whether the financial moves you made will come back to bite you in the...you get the idea.

So my advice is pay down your mortgage as you were planning so you can lower your monthly expense nut in retirement. Or put the money you would have used to pay down the loan into a nice mutual fund so you'll have that cash to fall back on after you retire. (For fund recommendations, check out our MONEY 65).

And if you still need some extra cash in retirement, you always have the option of tapping the equity in your home through a reverse mortgage. (For more on that option, click here.)

But if I were you, I would I not go along with your adviser's recommendation. And I'd consider looking for a new adviser.

_________________________

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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer LIBOR Warning: Neither BBA Enterprises Limited, nor the BBA LIBOR Contributor Banks, nor Reuters, can be held liable for any irregularity or inaccuracy of BBA LIBOR. Disclaimer. Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.