Betting your home against Wall Street

NEW YORK (Money) -- Question: I've been hearing a lot about "equity harvesting," or the practice of taking equity out of my home and investing it the markets. Do you think this is a good idea? What are the pros and cons? - Rich, Tampa, Florida

Answer: Whether someone refers to it by a fancy name like "equity harvesting" or "equity maximization," as I've seen some advisers call it, what we're really talking about is nothing more than borrowing against your home equity and then investing the loan proceeds.

There are all sorts of ways to do this. You can do a "cash out" refinancing so that you get your equity and end up with a new mortgage. Or you can take out a home equity loan or line of credit.

For that matter, I've even seen some advisers recommend refinancing every few years so that you can not only borrow the equity you have today, but the additional that builds up in the future as you pay down your mortgage and your homes' value appreciates.

On the surface, this seems like a can't-lose proposition. I've even seen web sites that suggest that only financial dummies would hesitate to do this.

After all, if you can borrow against your home's equity today at 6 to 7 percent and invest the money in stocks that historically have gained about 10 percent a year over the long term, you're essentially raking in 3 percent to 4 percent a year without doing a thing.

So by not doing this, you're in effect turning down free money, right? Why would anyone want to do something as stupid as that?

Well, I can think of a few reasons. Let me start, though, by saying I'll be the first to admit that if everything proceeds without a hitch, borrowing against your home and investing the money in stocks or some combination of stocks and bonds does have a decent shot at succeeding over the long run.

The reason is that you would expect equities (stocks and stock mutual funds) to have higher long-term rates of return than debt (bonds, mortgages, etc.). No surprise there. Stocks are riskier.

When you borrow against your home, you're paying the lender a "debt" rate of return and you're investing the loan proceeds at a higher "equity" rate of return (or something between the equity rate of return and the debt or bond rate of return if you invest in a portfolio of both stocks and bonds).

If you earned, say, the average long-term annualized stock return of 10 percent a year on your investments and paid 7 percent a year for the loan, you'd come out ahead by 3 percent a year. So the theory makes sense.

We don't live in a theoretical world, however. We live in a real world where there are all sorts of potential complications that can intrude. For one thing, while we're all fond of talking about average returns for stocks, those returns don't include expenses.

You can argue about what those expenses might be for a given individual, but if they're one percentage point a year, then that long-term return is cut to 9 percent. Which whittles your margin down to 2 percent.

I'm leaving out taxes for simplicity's sake here. If you assume the loan interest is tax-deductible and the investment gains are taxable and the two tax rates are similar, the margin would be slightly less. But the tax effect, however it may alter the margin, doesn't affect the underlying principle.

The bigger issue, though, is the assumption that you're virtually guaranteed to earn more on your investments than you'll pay for the loan. Yes, that's likely to be true if you look at annualized long-term rates of return.

But in reality we don't earn long-term annualized rates of return. We earn our returns month-to-month and year-to-year. And when you look at equity harvesting that way, you can see that it's quite possible that there are periods when your investments can earn less than the loan rate or, for that matter, even suffer losses.

If you had harvested $100,000 in home equity back in the beginning of 2000 and invested the loan proceeds in a diversified portfolio of large stocks like the Standard & Poor's 500, you would have had a loss of 14.6 percent a year for the next three years. And today, seven and a half years later, your $100,000 would be worth just $113,000, for an annualized return of just 1.6 percent.

Back then, you might have been more likely to invest in the mighty NASDAQ stock index, which was the place for the "smart money" of the go-go '90s. And had you done that your hundred grand would be worth roughly $66,000 today.

Given enough time you could eventually come out ahead and earn more than the interest rate you paid to borrow your home equity. But we're talking about a hanging in a very long time and, given this sort of setback, I can't help but wonder whether many people would do that - or should, for that matter. I'm not suggesting that you should go into every investment expecting the worst. That wouldn't make sense.

You should be willing to take the prudent risk of buying equities when you're investing for long-term goals, especially for retirement. But you've got to be especially careful whenever you're investing borrowed money.

That's because there's always the possibility that a setback in the markets could leave you with a loan balance that exceeds the value of the investments you funded with the loan. Just how serious a problem such a situation would be would depend on how much equity you withdrew from your home and how badly your investments had fared.

But if you ended up in a situation where you had to sell your home (say, because of a job transfer or because you lost your job and could no longer afford the payments) at the same time that your investments had taken a hit, you could find yourself with less money after paying off all your housing debt than you would have had prior to embarking on your equity harvesting scheme.

And if house prices had also fallen at the same time in your area after you borrowed against your equity, you would be in even tighter straits.

Frankly, I think the main purpose of home equity is to provide you with a financial cushion, not a way to arbitrage the difference between debt and equity returns. It's a reserve you can dip into if you really need it during your career, say, to help fund a child's education or tide you over during layoffs and such. For most people it's also effectively part of their retirement nest egg, which they can tap either by trading down or by taking out a reverse mortgage.

So whether it goes by the name equity harvesting or equity maximization or some other catchy term, I can't recommend engaging in a scheme that jeopardizes that cushion.

To anyone who feels differently and wants to give it a try, I'd suggest they first ask themselves a few questions, such as: What happens if my investments don't do as well as I expect? What's the downside scenario? What would happen if I had to unexpectedly sell my house and pay off all the debt? How will I make the higher monthly payments that will come from taking on more debt?

If after asking these questions someone still wants to forge ahead, then at the very least I'd recommend limiting the borrowing to only a small portion of home equity so there's still lots left over if something goes wrong. After all, it's always nice to have a cushion.