Not too long ago, debt was an asset. With high tax rates and deductible interest, debtors bore only a small portion of the interest expense. And with inflation high, it made sense to buy an appreciating asset with debt and pay back the debt with dollars that declined in purchasing power each year. The best advice under those circumstances was to buy the most expensive house you could afford with as much debt as you could qualify for and never pay the debt. Debt and leverage were the way to go.
But times have changed. Debt-free home ownership now is a goal for many Americans, especially older Americans. And some younger people are opting for 15-year mortgages instead of 30-year loans, while others are pre-paying their mortgages in small amounts each month.
But is debt-free home ownership the smartest move? Can your wealth be increased by tapping that equity and putting it to work in the markets? Let’s take a look at the numbers and see.
The first consideration before looking at the numbers is how you feel about having a debt-free home. If a free-and-clear home gives you peace of mind while having debt on the home makes you uneasy, don’t read any further. Some people get great comfort from knowing that they have no mortgage payments and that no matter what might happen to their income, the home is secure. If that describes you, shoot for debt-free home ownership. But if you are looking for the most profitable way to manage your assets, I’ll show you how to evaluate the options.
Suppose you have a fully paid off house, and decide to borrow $100,000 of the equity. Based on the ads in my area, you would pay interest at about 7.8% per year for 20 years. As a home equity loan, for most of you the interest is deductible if you itemize deductions. In the 31% tax bracket, that brings the effective interest rate down to 5.38%. If you invest the money to yield 8%, you’ll owe taxes on the income and have an after-tax return of 5.52%.
That puts you ahead of the game, but not by much. You are taking a risk that the tax laws won’t change and that you’ll be able to keep up that 8% return for the entire 20 years of the loan. That doesn’t look like a good risk to me. A small change in the markets or the tax law means you could lose money on this strategy. The spread between the interest you pay (after taxes) and the return you earn (also after taxes) has to be wider. That means for this strategy to make sense you need a higher return (or a lower borrowing rate).
It’s tough to find an interest-bearing investment yielding more than 8% these days. You could go with high yield bonds, emerging market bonds, or one of the adjustable rate funds, such as Pilgrim American Prime Rate Trust (PPR on the New York Stock Exchange). But the emerging market bonds carry a lot of risk. The others have enough yield now to make the strategy worth while, but if interest rates keep declining you won’t earn this yield for the next 20 years. If you are in a high tax bracket, long-term tax-exempt bonds held to maturity might provide a high enough after-tax yield to make the strategy work.
Generally you’ll need to invest in stocks or in a balanced, diversified portfolio with a majority of it in-vested in stocks. My recommended Sector Core Portfolio would be a good choice. You’ll also get tax benefits from investing this way. If you make few trades and buy mutual funds with low annual distributions, you’ll pay taxes only at long-term capital gains rates, and you won’t have taxes eating into your return each year. You’ll be able to com-pound some gains tax-deferred, increasing your after-tax return. Your after-tax return is a key to maximizing the benefits of this strategy.
If stocks get the return of the last 20 years, you’ll look like a genius. But don’t count on that. If you can invest the loan to earn 12% annually, your investment fund will have $964,630 after 20 years (before taxes), and $791,704 after paying capital gains taxes. But a 10% return knocks the pre-tax total down to $672,750. You can see that relatively small changes in the rate of return dramatically effect the bottom line over 20 years. Meanwhile, you’ll make about $197,000 of interest and principal payments on the loan.
You’ll want to consider tapping your home equity to invest only if you will invest to achieve a rate of return significantly higher than the interest on the loan. Don’t invest in treasury bonds, certificates of deposit, or money market funds. For the strategy to work, you’ll have to invest in stocks or at least a balanced fund and be able to ride out the ups and downs of the market. That means you should be able to make the regular loan payments from your other income, so you won’t have to tap the investment portfolio and reduce your long-term return.
Also, be sure about the tax effects. A key consideration is the deductibility of interest. Many people don’t realize that they are considered “high income” taxpayers, which causes them to lose part of their itemized deductions each year. Your itemized deductions are reduced by 3% of the amount by which your adjusted gross income exceeds a base amount. In 1999 the base amount is $126,600, whether you are a single taxpayer or a married couple filing jointly. So if your adjusted gross income is $150,000, you lose $702 of itemized deductions ($150,000 minus $126,6000 times 3%). Verify the amount of your interest deduction.
Another factor is closing costs and any other expenses related to the loan. In my area it is pretty easy to get a home equity loan without having to pay any costs. But if you do pay costs, these must be considered to determine if borrowing to invest will increase your net worth.
The same analysis should be used if you are buying a new home and trying to decide if you should buy it with cash or take out a mortgage and continue to invest your cash. Compare the after-tax interest you’ll have to pay on the mortgage with the after-tax return you believe you can get from investing the cash.
In either situation I wouldn’t count on earning the 18% annual returns the stock market has generated over the last 18 years. And you must be sure to keep the money fully invested even after the stock market has one of its periodic losses of 20% or more. If you might be tempted to sell so that you don’t lose any more, then you probably should not consider this strategy.
Borrowing against your home equity can increase your net worth. But you must invest primarily in stocks, stay fully invested over the life of the loan, and believe that over the life of the loan the stock market will achieve its historic returns of 10-12%. Otherwise you are better off working to own your home debt-free and investing your other assets. Then tap your home equity only when you really need the cash.