Borrow on Your Mortgage to Invest in Common Stock?

December 4, 2006, Revised July 21, 2009, Reviewed April 10, 2011

"I went to a financial services seminar recently where they were advising people to stop paying down the balance of their mortgage by refinancing into an interest-only loan, investing the cash flow savings in an indexed stock fund yielding 9% purchased through them. What do you think of this?"

I like it a little better than the usual prescription of investing the cash flow savings in annuities. However, some borrowers can’t do it profitably because their cost of funds is too high, and others shouldn’t do it because the risks are too great.

The Best Case

Let’s assume you have a house worth $400,000, a 6% mortgage for $320,000, and your investment strategy is to pay off the mortgage. The monthly payment on your fully amortizing mortgage includes a principal component that reduces the balance every month. That payment of principal, which rises every month as the interest declines, is an investment that yields 6% with zero risk.

An alternative strategy is to convert the fully-amortizing mortgage into one that is interest-only, investing the cash flow savings in an indexed stock fund – a fund that holds the same stocks as those in a major stock index, such as the S&P 500. Since you will no longer be investing in mortgage repayment, this strategy is the same as borrowing at the mortgage cost in order to invest in the index fund.

Since the index is expected to yield about 9% over a long horizon, and assuming the cost of funds is 6%, you will be earning a 3% spread, plus tax benefits. The mortgage interest is deductible in the year paid, whereas a major part of the return on the index fund will be capital gains on which the tax rate is lower, at least today, and payment is deferred. If all goes as planned, you end up wealthier, even though you may never pay off your mortgage.

Here is an illustration. At 6% and 30 years, your $320,000 mortgage would have a fully-amortizing payment of $1918.57, of which $1600 is interest. If you switch to an IO, your monthly cash flow saving is $318.57. If that amount is invested every month to yield 9%, your stock fund after 30 years would be worth $583,220. Of course, you would still have a $320,000 mortgage balance, but you would be ahead by the difference of $263,220.

The Cost of Funds to Implement the Stock Investment Strategy

The best-case description above followed the practice of those marketing the plan of glossing over the cost of the funds invested in stocks. They assume, as I did above, that it is the rate on the refinanced mortgage, but that is wrong. If the borrower raises funds with a cash-out refinancing, the cost includes the loss of a lower-rate old mortgage (if there is one) that the borrower would have enjoyed had he kept to his mortgage payoff strategy.

For example, a borrower recently wrote me that, at the urging of his broker, he planned to raise $62,000 for investment by taking out a new mortgage for $200,000 at 6%, repaying the balance of $138,000 on his existing loan which carried a rate of 4.75%. I told him that the cost of the $62,000 that he would invest in stocks was not 6% but 8.78%, after accounting for the increase in rate on $138,000. He had to earn 8.78% just to break even.

Similarly, if a borrower refinances into an interest-only (IO) in order to invest the cash flow savings in stocks, the cost of the cash flow includes the loss of the lower rate on the non-IO version of the mortgage that would have been used had the borrower pursued a mortgage payoff strategy.

For example, in another article I describe a house purchaser who was considering a 30-year FRM IO at 6.375% rather than the non-IO version at 6.25%, with the intention of investing the cash flow savings on the IO. I calculated the cost of those savings at 8.35%, after accounting for the higher rate on the IO. See Invest the Cash Flow Savings on an Interest-Only?

If a borrower refinancing into an IO also has an existing mortgage with a low rate, the cost of funds could be well in excess of the return on stocks.

Risk and Market Volatility

An important factor to consider in assessing this investment strategy is whether or not you are comfortable with the risk. The expected return of 9% is based on experience over long historical periods, it is not promised by anyone; the actual return could be lower or higher.

Furthermore, stock prices decline as well as rise. You have to be prepared to endure periods of uncertain length during which your wealth will decline. It is not a strategy for those with short time horizons or nervous stomachs.

Transactions Costs

The net return on investment is going to be reduced by transactions costs, starting at the outset with the refinancing. In addition to the usual settlement costs, the people merchandising this plan expect to make a commission on the new IO mortgage, as well as on delivering you to an index fund.

In the future, your investment can’t keep pace with inflation without incurring more transactions costs. If your $400,000 house today appreciates at about 5% a year to $1,000,000 over the first 10 years, you can refinance for $800,000 or even more, but only the interest on $420,000 would be deductible. That is because only acquisition indebtedness is fully deductible (up to $1 million); deductibility of other mortgage debt is limited to $100,000. To get the full deduction, you would have to sell the house and buy another of equivalent value, which is very costly.

If you decide to go ahead, doing it on your own will avoid a host of transactions costs. Find the best available refinance deal by selecting a certified loan provider, and find your own index fund. That is really easy to do, you merely select the fund with the lowest expense ratio.

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