Are You Missing Out on a Fortune?

A lot of get-rich-quick ideas are just plain dumb. A few, though, have some truth to them, as long as you understand the risks.

One popular idea, supported by writers like Missed Fortune author Douglas Andrew, is to borrow as much as you can on your home. Rather than using available money to pay down your mortgage, you instead invest it in the stock market. Over time, this strategy can bring you extra profits -- if the market behaves.

The basic concept
In past generations, a family's biggest financial accomplishment was to pay off the mortgage. Homebuyers made large down payments, and if they ever came into extra cash, paying down the mortgage would have been near the top of their list of what to do with it.

Yet paying down your mortgage locks up money in your home -- money that you could instead use to invest in stocks. Given the market's historical return of around 10% annually compared to prevailing mortgage rates around 6%, it looks like a no-brainer to max out your mortgage and invest in an index fund. You'd essentially pocket an extra 4% of return every year.

If you're more willing to take risk, you might do even better than 10% in individual stocks. For instance, if you'd taken $25,000 five years ago and invested it rather than paying down a 6% mortgage, here's how much you could have made:

Stock

$25,000 Invested in 2003
Is Now Worth

Net Profit After Paying
6% Mortgage Interest

Halliburton (NYSE: HAL  )

$109,603

$77,103

Garmin (Nasdaq: GRMN  )

$54,541

$22,041

Oracle (Nasdaq: ORCL  )

$43,548

$11,048

Transocean (NYSE: RIG  )

$157,405

$124,905

Source: Yahoo! Finance.

In addition, those profit figures don't include the benefit of tax deductions on mortgage interest. Since stock dividends and capital gains get taxed at lower rates, your net after-tax profit can be even greater. Use the money to invest tax-free in a Roth IRA, and you end up with even more money.

When things go wrong
The problem with the strategy is that actual market returns don't follow predictable patterns of steady growth. For instance, over the past decade, the S&P 500 has returned about 4% per year. Since 2000, the figure is even lower -- less than 1%. If you're paying 6% in mortgage interest, you've lost 2%-5% each year by not paying down your mortgage.

Again, here's an example: Say that in 2000, you had $25,000 that you could use either to pay off your mortgage or invest in stocks. If you used it to pay down your mortgage, then it's still there as home equity, having helped you avoid interest payments. However, if you invested in stocks by using an S&P 500 index fund, your stocks would have earned just more than $1,500, yet you would have paid an extra $12,000 in interest over the past eight years.

The problems are even more severe if you picked the wrong stocks to invest in. Here are some examples:

Stock

$25,000 Invested in 2000
Is Now Worth

Net Loss After Paying
6% Mortgage Interest

Microsoft (Nasdaq: MSFT  )

$24,795

($12,205)

Merck (NYSE: MRK  )

$18,773

($18,227)

Citigroup (NYSE: C  )

$14,683

($22,317)

Source: Yahoo! Finance.

Paying down your mortgage is a conservative investment. It saves you a fixed amount of interest, but it gives you no potential for growth. In contrast, investing spare cash has the potential for higher returns but brings additional risk.

Depending on your risk tolerance, your portfolio's overall asset allocation, and your mortgage rate, paying down your mortgage isn't necessarily as dumb as some advocates make it out to be. Indeed, when other investments are doing badly, it can be the best place to put your cash.

More on making the most of your money:

  • How an online tool is changing the way people analyze stocks.
  • What it takes to win in this market.
  • Why you're too broke to stop investing.

Microsoft is a recommendation of Motley Fool Inside Value. Visit Inside Value for the next month, free, to see how focusing on stocks with a margin of safety can enhance your returns.

Fool contributor Dan Caplinger uses all of these strategies, but he doesn't own shares of the companies mentioned in this article. Garmin is a selection of Motley Fool Global Gains and Motley Fool Stock Advisor. The Fool's disclosure policy is a winning strategy.


Read/Post Comments (3) | Recommend This Article (6)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 03, 2008, at 1:06 PM, Richthofen80 wrote:

    Borrowing against a home to play the market is a DUMB idea. Leveraging in general is only for serious proferssionals and even then, those professionals can get wiped out by playing with other people's money. Don't play with other people's money. Pay your mortgage because you need to live in a home. Play the market with outright cash, not 'equity' money.

  • Report this Comment On June 03, 2008, at 2:18 PM, eckertbt wrote:

    If you bet the farm, you might lose the farm.

    I may be alone on this, but my peace of mind is worth far more than the potential to earn 10 or 20 thousand dollars.

    In the job market, many people have turned down lucrative job offers for higher pay because it will rob them of their balance or force them work somewhere where they don't want to.

  • Report this Comment On June 04, 2008, at 9:37 AM, TMFMarlowe wrote:

    "If you bet the farm, you might lose the farm."

    eckerbt, that's as well-said as I've ever heard it. There's a point worth making over and over. Anyone who is tempted to go that route needs to soberly ask themselves whether their "risk tolerance" includes a tolerance for the risk of homelessness.

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