Personal Asset Allocation

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CFAexams

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In the USA, the interest portion of mortgage payments are tax deductible. Having said that would it be better to invest in the market then to pay down a mortgage?

My average return in the world markets has been 15% per year +/-5% deviations every year. Mortgage rates in the USA range from 5%-7%. Does it seem as though real estate is quite a leverage tool to invest in equities?
 
Check out:

http://www.nasd.com/InvestorInformation/InvestorAlerts/MarginandBorrowing/BettingtheRanchRiskingYourHometoBuySecurities/NASDW_005961
 
No. Leveraging cas flow to invest will cause more debt and interest expense. Also, this strategy in today's market will not give you the reward for the amount of risk you will take.

IE: Home: 250,000 Free and Clear. You take a credit line 25,000 8% Interest Rate.

You invest, and get 12% Rate of return=

You incurrend 184/Month pay off debt * 12 = $2208 expense
You made $3000 Profit

Gross Profit Pre Tax Not including commissons and other charges = 792

Risk Free Money Market pays 4% = 1000 Profit!

Hope this helps.
 
Zforce12000 Wrote:
-------------------------------------------------------
> No. Leveraging cas flow to invest will cause more
> debt and interest expense. Also, this strategy in
> today's market will not give you the reward for
> the amount of risk you will take.
>
> IE: Home: 250,000 Free and Clear. You take a
> credit line 25,000 8% Interest Rate.
>
> You invest, and get 12% Rate of return=
>
> You incurrend 184/Month pay off debt * 12 = $2208
> expense
> You made $3000 Profit
>
> Gross Profit Pre Tax Not including commissons and
> other charges = 792
>
> Risk Free Money Market pays 4% = 1000 Profit!
>
> Hope this helps.


So RFR based profit is $1000. Why are you comparing that to the $792? You still had to borrow the $250,000 at 8% (let's assume interest only) for $2000 in pretax expense. Even if it's 50% tax deductible between fed/state/local you still net a $0 vs the $792 pretax (on a non-risk adjusted basis).

In reality, EVERYONE who owns a home and makes a decent living does what CFAExams says. When you buy the home you don't use every penny of your saving for the down payment, and most people don't end up using every extra dollar that comes in to pay down their mortgages. You're using an example of no mortgage and taking acredit line. The more common reality is a home with a mortgage balance due, and money saved and invested. I think most people try to keep that liquidity if their mortgage fixed interest rate is low enough (or refinance down when rates drop) to allow them to keep some liquid cash that they can invest to take advantage of strong market periods, and avoid the risk of needing cash in a high interest rate environment and tapping into home equity under those unfavorable conditions.

i would never recommend leveraging up the wazoo ( a technical term) against your home, but if you have say 50% equity with a low mortgage and cash in the bank, I don't think there's any reason to use the cash to pay down the mortgage, and even less reason to earn money market rates on it.
 
So Super I: What is your point? The post was whether or not to use home equity to invest. My position is not a good idea. Do you agree? I did not understand your position?
 
I thought my last paragraph was pretty clear.

The phrase/concept "use home equity to invest' is just meaningless.

Person A has a home worth $500,000 that he bought 10 years ago and has a $200,000 mortgage. He refinances to take advantage of low long term fixed rates, takes out $100,000 and puts it in the market.

Person B buys the home next door also worth $500,000. He is sitting in $300,000 pre purchase and decides to put down $200,000 taking a low fixed rate mortgage. and invests the rest of his cash.

They both have $300,000 mortgages and $100,000 in the market. Did they both use home equity to invest or just the first guy?

My point is that if you have a mortgage balance >0 and at the same time you have investments>0 then you are in effect using home equity to invest. As I said in my last paragraph in my other post there is nothing wrong with this as long as you excersize restraint.

The other factor to consider is the benefit of diversification. Using you example your assets are 100% in real estate (let's ignore likely retirement assets, etc.). Borrowing a nominal percentage of your equity and investing it allows you to achieve diversification, which can reduce your overall risk profile.
 
Well, I haven't walked through the math on a spreadsheet, but here is my gut reaction:

1) probably not a good thing to try right now unless you have lots of home equity and aren't worried about your home value dropping as we figure out what's going to be happening to the housing market. Even if you are in this situation, there are things to consider.

2) if you are taking out a new home equity loan, the transaction costs are likely to jack up your effective APR, so be sure to consider that. If you have a home equity line of credit, it is concievable that you could do this, but it still might not be a good idea.

3) true that the effective cost of the loan is (loan rate) * (1 - marginal tax rate), so if you are in at a 8% loan and in the 25% tax bracket, the after tax effective interest rate is about 6%. Be sure to compare this to your margin rates. I don't remember if the earlier post that went through the math included the tax effect - if so, it wasn't obvious to me.

4) I believe the IRS code does say somewhere that the tax writeoff for home equity or HELOC is for uses that substantially contribute to the maintenance of the property. It's a wierd part of the tax code, but in an audit, if they discover that you are using home equity to finance lots of other things, vacations, cars, etc.., they can theoretically charge you back taxes on that. (I'm not 100% sure of this, and how the details work, but I remember reading through some fine print once that mentioned this). Lots of people do it anyway, since it seems like a difficult thing to enforce.

5) leverage with home equity has the same risks as traditional margin leverage, with the one exception that you won't have to meet margin requirements. If you have true investment skill and can ride out large drops in your position, then using home equity could be an advantage. However, are you really sure you have that much skill? It's more likely that you will over-leverage because of this, which makes your bets riskier. So, if you are very confident in your investment skill, you might do this, but if I wanted to invest in you and you said you were going to do this, I would probably keep my money away from you.

Anyway, not promising to be the guru here, but these are my reactions. I'm happy to be corrected or ammended.

(I hadn't thought of SuperI's point about diversification - that makes a lot of sense. I wonder if there would be some kind of swap mechanism where someone can exchange their real estate risk for equity or other risk. I know they now have real estate futures in some markets, but that's just swapping one real estate risk for another real estate risk)



Edited 2 time(s). Last edit at Monday, September 11, 2006 at 10:33AM by bchadwick.
 
hi bchadwick, fyi i got your memo in my box the other day...just have not had a chance to write back yet. hope all is well
 
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