The right (and wrong) reasons to tap home equity

NEW YORK (Money) -- Question: I cashed in my investments to raise a 25% down payment to buy a house. I'm thinking of taking out a home equity line of credit, borrowing against it and then investing the loan proceeds. I figure this would be a good way to rebuild my investment portfolio. What do you think? - James

Answer: I think it's a good idea to open up a home equity line of credit that you can borrow against in the event of a financial emergency - a layoff, say, or to pay for a large expense you can't handle out of savings or cash flow.

But I think you're getting into risky territory when you start investing borrowed money. At first glance, your plan may seem like an easy way to use the bank's money to easily rack up investment gains for yourself.

After all, you can probably get a home equity line of credit at or below the prime rate, which is now 8.25 percent. Assuming the interest on the loan is tax-deductible (which you can ascertain by checking out IRS Publication 936), you're actually paying 6.2 percent in interest after taxes, assuming a 25 percent tax rate.

So all you've got to do to come out ahead is earn more than 6.2 percent after-tax on the borrowed money you invest.

Some may think that sounds like a sure thing. But actually, several things could go wrong.

Loan rates could move higher... The rates on home equity lines of credit usually aren't fixed. They're typically pegged to the prime rate. So if prime goes up, so will the interest rate on your loan. Which means you'd have to earn more on your investments to cover the higher interest cost. If you don't, you'd be "upside down" - paying more for your money than you're earning on it.

Okay, but perhaps you have special insight into the credit markets or a pipeline into Fed chairman Big Ben Bernanke's thought process that convinces you that interest rates aren't going up. That makes your plan a no-cinch winner, right?

Stocks could move lower... Maybe the investments you choose don't perform so well. Maybe you buy into a sector that looks like a sure thing (like real estate and gold did earlier this year) but then begins to sink.

Or maybe the stock market just runs into a wall and, despite all your savvy investing skills, stock prices overall experience a big setback. In that case, you could suddenly have a loan balance that's bigger than your investment portfolio.

Now, you may say that's no problem. After all, the market will eventually revive and in the meantime you're repaying the loan balance and interest out of your earnings. No biggie, right?

Well, that's true as long as you can afford to make those payments and you don't mind a chunk of your income going toward debt repayment instead of other things. Of course, if you happen to lose your job, that could make it difficult to make those loan payments out of cash flow.

Of course, in the worst-case scenario you might figure that even if your investment portfolio really tanked, you could always liquidate it, put the sale proceeds toward the loan and then refinance or even sell your house to repay rest.

But refinancing would mean taking on more debt and selling would likely involve quite a bit of personal turmoil. And if it turned out that home values had dropped in your area since you bought (which is looking like a real possibility for homeowners in some areas of the country, according to a recent study) it's entirely possible that you may not even be able to borrow or sell your way out of this situation.

Of course, it's also possible that none of these problems may crop up. Interest rates might stay flat, and you might earn a nice steady return on your portfolio. You won't get laid off or have other demands placed on your income. And everything will work out fine.

But what will you really have gained? It seems to me your gain will be limited to the difference in what you paid on the loan and what you earned on your investments after taxes. Let's say that difference is two percentage points. That means if you borrow, say, $50,000 and come away with a 2 percent net gain, you're pocketing $1,000 a year for all your trouble.

That might be worthwhile if this scheme were a lead-pipe cinch. But it's not. Oh sure, the risks seem remote. But that's always the way it is when people leverage their investments or concentrate their bets in one area.

Do you think the big brains at Amaranth Advisors, the formerly big hedge fund that recently lost upwards of $6 billion in energy investments thought those bets would turn against them? Do you think they thought they were doing something really risky?

Of course not. Our natural tendency is to think we've got it all covered. The reward seems assured and the risks seem small. It seems investors' brains are just wired that way.

In reality, though, we can't know all the risks beforehand, or for that matter, how they might play out. That's why so many people get hurt when a bear market hits or real estate prices fall or the payment on their interest-only mortgage resets.

So my advice is do yourself a favor and don't use your home equity line in some lame scheme to build an investment portfolio. Do that the old fashioned way. Save!

Start by contributing to a 401(k) plan at work if you have access to one. And outside the 401(k) start building an emergency fund equal to about three months' worth of expenses. (You can keep this emergency stash in a money-market fund.)

Once you've got that reserve and you're maxing out on your 401(k), you can look to other alternatives, like opening an IRA or investing in taxable accounts. (See more on investing options beyond a 401(k)).

Yes, it may take a bit longer to build wealth this way. But you'll be building your financial future on solid ground, not a shaky foundation of debt.

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