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 |
Net Profit After Paying |
|---|---|---|
|
Halliburton |
$109,603 |
$77,103 |
|
Garmin |
$54,541 |
$22,041 |
|
Oracle |
$43,548 |
$11,048 |
|
Transocean |
$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 |
Net Loss After Paying |
|---|---|---|
|
Microsoft |
$24,795 |
($12,205) |
|
Merck |
$18,773 |
($18,227) |
|
Citigroup |
$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.
