Is it wise to borrow against the family home to invest?
Borrowing home equity to invest is generally a loser’s game because the only road to success requires excessive risk.
With mortgage rates below 4% and the stock market moving ever higher, many people are tempted to extract their home equity to play in the markets. It’s hoped that investing over the long term will yield a rate of return in excess of the cost of borrowing that money.
Personally, I think it’s a foolish idea. Professional investors evaluated the risk and reward potential of a variety of investment alternatives and determined that providing the money for a home mortgage at 4% was the best risk and reward available. The only way an ordinary investor is going to beat the pros is to take on more risk — and get lucky.
Many people can beat the pros over the short term, and occasionally even the pros overestimate the risks and miss better opportunities, but for the most part, borrowing money to invest is a loser’s game.
Tips for homeowners considering investing home-equity in the stock market.
As home values rise, homeowners tempted to invest their equity in the stock market should answer these two questions:
1. What is my tolerance for risk?
2.Do I have enough in reserve holdings to cover sudden swings in home values and the market?
Over the past five years, the total return for the S&P 500, including dividends, averages out to 15.45% per year. Meanwhile, average annual interest rates on a home equity line dropped from 5.41% in 2010 to 5.05% in 2014, according to HSH.com. Given that math, a $100,000 home equity line held for the past five years would have cost a borrower $25,980, but invested in the S&P 500, that money could have more than doubled to $205,102.
This is the glib and foolish analysis people make before making a big mistake. The stock market has a much different risk profile than a mortgage loan. I have to wonder who good people feel when they borrow a lot of money, put it into the stock market, and then watch the value cut in half during a downturn. Realistically, most can’t take that kind of pain, and they end up selling for a loss and miss the rebound.
And why would someone take out a HELOC to play the market and pay 5% plus in interest. If they open a margin account, they can borrow money at 2% from their broker. Of course, if people borrow money at 5% and then margin that at 2:1 at 2%, then they are really playing with fire, and many people do.
That return sounds like a killer deal, but it’s also been during an unusual bull market, says David Blitzer, managing director and chairman of the Index Committee for S&P Dow Jones, a team of economists and analysts who maintain the S&P 500. “The last five years were not a typical five years; 2009 was pretty much the end of the recession, the bottom of the bottom,” he adds. “A rule of thumb [for an annual total return] is 6% to 7%, or a double in 10 years.”
Investors need to accept that they could lose money over any given five years in the market, and that money would be borrowed against the equity in their home, Mr. Blitzer says. In other words, if home values plummet, a borrower could be out not only the money invested but owe more than the home is worth, he adds.
Investors can accept the idea intellectually, but when the drawdown actually occurs, the emotions are much stronger than the intellect imagined, and they end up selling at a loss.
On the plus side, a “long-term” investment of more than one year would qualify for lower tax rates on dividends and capital gains tax rates. Tax rates are 20% for investors in the highest 39.6% income tax bracket, 15% for investors in the 25% to 35% brackets, and zero for those in the 15% lowest bracket.
In the best-case scenario, borrowers who want to invest home equity in the stock market should have the flexibility to either sell their investment sooner or hold it longer if market conditions get rocky, Mr. Blitzer says. In other words, it may be more risky for a homeowner who knows they are likely to move or sell the house within five years, he adds.
“Typically the stock market goes up and down faster and is more volatile than the housing market, even including the [recent] boom and bust,” Mr. Blitzer says. “If you wait long enough, you are probably going to come out ahead in the stock market, but there are certainly some cases where five years are not long enough.”
Here are a few more tips for anyone contemplating a home equity line or loan:
• Fees differ among lenders. Borrowers who shop around may save. Some lenders charge no fees for their home equity products while others may charge closing costs, third party origination fees, mortgage taxes and annual fees, Mr. Potere says.
• Relationships may matter. Conversely some banks offer discounts to customers who already have other accounts. For example, Bank of America Preferred Rewards members may save up to 0.375% on a home equity line interest rate.
• Don’t forget AMT. Taxpayers subject to the alternate minimum tax need to keep in mind that they won’t be able to deduct home equity interest.
If you plan to borrow money to invest in stocks — an idea I think is foolish — don’t borrow against your home. Get a margin account at your brokerage and pay a fraction of the cost of a mortgage, and don’t risk the family home.
Even those who plan to invest for the long term should ask themselves what their goals are before taking the plunge. Most who consider this idea are saving for retirement, but they only have a vague notion of what that really entails.
In retirement, what determines the amount of money available to enjoy for lifestyle expenses? Is it wealth? Is it home equity? Not really. The biggest determinant of lifestyle spending in retirement is the stability of the sources of cashflow the retiree controls.
Many are obsessed with being rich when what they really want is unlimited spending power. People who have attained great wealth may have amazing spending power, but they seldom use it. If they did, they would not be rich.
Being rich is about forming a habit of saving and consistently spending less than what’s earned. It is about having the self-discipline to limit spending voluntarily rather than being forced to by a lender’s credit limit, a skill few master.
Most people work because they need a large amount of stable cashflow to cover personal spending and provide a balance to save. Everyone needs to work until they acquire enough assets to provide a stable source of cashflow from another source — their investments.
The quality of life and the quantity of available spending money in retirement is directly related to the sources and stability of cashflow people control and direct. The quantity of money or total net worth is not as important as the ability to convert it to cash.
The problem with asset appreciation as the primary method of funding retirement is that this appreciation must be converted to cash in order to be used. This cash can be obtained through sale or through borrowing. Sale is the cleanest, and it’s simple with stocks or other securities that you can sell part of, but houses are different. It is difficult to sell a partial interest in a house. Usually, people need to borrow the money to stay in the house, which means either a reverse mortgage, or HELOC dependency.
Borrowing money is a bad way to go because compound interest working against the borrower. The longer the borrower lives, the more they borrow, and the more interest on interest they pay. It is an airplane in a nosedive picking up speed heading to certain doom.
Cashflow investments like (1) dividend stocks, (2) bonds and other debt and (3) real estate are all worthy components of a balanced portfolio. Realistically, few people actually hold stocks or bonds for their cashflow. Most will trade these instruments if only by proxy through a mutual fund.
Real estate is the one cashflow investment that people are more familiar with because everyone has a house, even if it’s rented. It is also a great cashflow investment. Everyone should consider strategies for owning real estate as part of their retirement savings.
What I am proposing is different than what most people think when they invest speculate in California real estate. It doesn’t matter what it it resells for; appreciation is not important. Buy to obtain maximum future cashflow.
Real Estate as Cashflow
Real estate provides cashflow either through (1) renting the property or (2) living in it and saving the cost of a comparable rental. Most people put about one-third of their income toward their housing expense, a significant expense. If they owned the property with no debt, they enjoy the benefit of that money in other ways.
With cashflow rental properties, investors want to get the largest possible cashflow for the least amount of money. They shouldn’t focus on appreciation potential because it often induces them to overpay and dilute the cashflow returns.
Any investor who owned three properties with no debt where each one represented a market rent equal to one-third of their yearly income, they would have a stable income without having a job — other than perhaps property manager… if they wanted…
The retirement hurdle: own three properties of equal quality to what people pay for rent or ownership today with no debt.
Living in Retirement
There is one group that will save nothing. They will have to chose between working until they die or living on about one-third of their lifetime wage average through Social Security. This is the minimum entitlement in our society as granted in the Social Security Act of 1935.
According to Wikipedia, “… the Social Security program began as a measure to implement “social insurance” during the Great Depression of the 1930s, when poverty rates among senior citizens exceeded 50%.” Social Security is the collective price of societal compassion to its senior citizens. I am glad it’s there.
How well people live above and beyond this minimum entitlement depends on their stable future cashflow from their investment savings.
The conventional wisdom among financial planners is that people need about two-thirds of their work salary as monthly spending to live comfortably in retirement. Social security gets you one of those two-thirds. Anyone who pays off their primary residence obtains the remainder there. Paying off a home and living on Social Security in retirement is still an option in the United States, which is why I believe paying off a mortgage is the best retirement plan.
Paying off Your Home
Paying off a Home mortgage became passé during the Housing Bubble because people erroneously believed they had better things to do with their money than retiring debt. Debt was cheap and abundant; why pay it off under those circumstances? Paying off a house as an investment strategy nearly died. Did anyone keep their conventional mortgages during the bubble?
When people retire debt, they no longer have to service it. For those that keep a revolving credit line at its limit, this is a strange concept, but retiring debt is fundamental to having a stable retirement. Do people want to work and service debt forever? Who is the slave and who is the master?
Paying off a home mortgage removes an enormous financial drain from the family’s balance sheet and greatly improves an income statement; it is an historic measure of success.
Paying off Investment Property
Anyone who pays off their home plus one other investment property — like perhaps their starter home — they have more than enough stable cashflow to live comfortably in retirement. (1) Social Security plus (2) a primary residence with no debt and (3) a paid off starter home as an investment equals (=) a prosperous retirement.
It is an old investment strategy to keep a small condo or first-rung property, and it is a good idea if the property is financed with a conventional mortgage. Unfortunately, most people simply used these properties as sources of additional leverage in building their speculative empires.[dfads params=’groups=4&limit=1&orderby=random’]
When people purchase their first property, it should be near rental parity. Ten years later, that property should have a positive cashflow due to 10 years of escalating rents.
If they keep the property, they can take the excess rent and put it toward the mortgage paying off the debt more quickly. Remember, the goal is to have maximum free cashflow in retirement, so people should work to pay off those debts.
Debt equals delayed retirement.
Anyone who (1) saves money, (2) acquirse assets with maximum cashflow and (3) pays off debts will be successful and enjoy a very comfortable retirement. Real estate should not be the only component of a retirement savings plan, but it will be an important one.
I hope this provides a way of looking at real estate that benefits you.