Should you borrow against your house to buy stocks?

By Felix Salmon
March 10, 2011
back and forth with Linda Stern, I took the advice of commenter Kid Dynamite and moved the discussion to email.

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In the wake of my back and forth with Linda Stern, I took the advice of commenter Kid Dynamite and moved the discussion to email. Here’s how it went:

Felix: Why do you think it makes sense to borrow against your house to invest in the stock market? And if it makes sense for people buying houses, why doesn’t it make sense for people owning houses? If I own my home outright, should I take out a mortgage and invest the proceeds in a mutual fund? If not, why not?

Linda: My advice, intended for first time homebuyers who are trying to save up for a down payment, was based on the belief that both mortgage interest rates and home prices will rise faster than they can accumulate big down payments. Using leverage like this allows them to lock in a historically low mortgage rate and a home price, and start building equity in a home. If you already own a home, you wouldn’t need to lock in the home, so, no, I don’t think it’s necessarily wise to remortgage it for investment cash. That being said, if you have an outstanding mortgage with a fixed interest rate of 4.8 percent or less, I think it would probably be the better bet to take any extra money you have and invest it in a diversified fund instead of using it to pay off your mortgage early. If you could do that through a tax-advantaged retirement vehicle, that would be even better.

Felix: OK, let me try again. It seems to me, just like it seems to my commenter Kid Dynamite, that you’re making two different claims in your posts. The first is that first-time homebuyers without much of a downpayment should buy now anyway. The second is that even if you do have a large downpayment, you shouldn’t put it all into your house, and instead you should invest that money in a diversified mutual fund. I’m trying to concentrate on the second claim here. So, let’s build four different scenarios here; let’s assume they’re all at an interest rate of 4.8%, and that in every case the homeowner can comfortably make her mortgage payments.

  1. Alison is buying a house for $250,000. She has $50,000 — 20% of the price — in savings which she can use as a downpayment. You suggest that she should not put all that money down, and instead should invest some of it in the stock market. “The less you put down,” you write, “the better off you are”. So if Alison can buy the house with just 3.5% down, or $8,750, should she be investing roughly $40,000 of her savings in the market rather than using that money as a downpayment?
  2. Brenda already owns her house, which is worth $250,000, and it carries a $200,000 mortgage which she wants to refinance. If the lender is willing to refinance for more than $200,000, should she accept the offer of a cash-out refinance and invest that new cash in the market?
  3. Christie is in the same boat as Brenda, except that her outstanding mortgage, which she wants to refinance, is much smaller — just $50,000. How much should she refinance for, in the knowledge that she will take any extra cash and invest it in a mutual fund?
  4. Debbie owns her house, worth $250,000, outright. Should she take out a mortgage of any size at all, and invest the proceeds in the market?

In each case, homeownership is a given: Alison, Brenda, Christie and Debbie are all going to own that house either way. I’m just trying to zero in here on the idea that you should borrow against your house and invest the proceeds in stocks. When is that a good idea, and when is that not a good idea? And if it’s a good idea for Alison to have less than $10,000 of equity in her home, why is that not also a good idea for Brenda, Christie, and Debbie?

Linda: Sorry, Felix, you’re not going to get me to give individual advice about who should and who shouldn’t use home equity to invest in the stock market. That depends on many variables that you don’t go into here: How much do you already have saved for retirement or invested elsewhere? How intelligently do you invest? What’s your ability to withstand risk? When will you need the money? How comfortable is your income stream? Etc. etc. etc. My main point is that a homeowner who can comfortable make their mortgage payments on a fixed 4.8 percent home loan could probably find better places to put extra cash, rather than buying down the loan. For someone, that might be an emergency fund. For someone else, that could be a Roth IRA invested in a balanced mutual fund. I’m not going to tell any of your readers or mine to remortgage their paid-off homes and put all the cash in stocks. But I’m sure there are some folks out there — well-heeled and well-capitalized folks — who would do that, and would end up happy for it.

Now let me answer your question another way: I, personally, have taken cash out of my paid-off home to pay for home repairs while at the same time contributed money to my IRA. Isn’t that the same thing?

Felix: Linda, of course I wasn’t asking for individual advice any more than you were giving individual advice when you wrote your initial posts. But back then you seemed quite happy to generalize and say that the less you put down, the better off you are.

My point is that your advice seems to be, shall we say, path-dependent. If you start off with no house, then you’re advising putting as little money down as possible. If you start off with lots of house, on the other hand, you’re shying away from making the same advice to lever up, even if it brings the homeowner to the exact same place.

Economics is full of cases where people will make different choices depending on how the choices are presented. Here’s a good example. But as personal-finance columnists, it’s incumbent upon us to point out those areas of irrationality and to to say that if you have the choice between A and B, then you should plump for the outcome which makes the most sense, regardless of how you get there. The choice facing Alison is the same as the choice facing Brenda. Your original column was quite clear about what Alison should do, but now you’re backtracking on what Brenda should do. And that’s why it seems to me that what you’re advising is irrational.

For me, the choice in all cases is clear: it’s pretty much always a bad idea to borrow money and invest it in the stock market — and it’s an even worse idea to borrow money against your house and invest it in the stock market. Because that way you not only risk losing money in the market, you also risk losing your house. I’m sure you can come up with an extreme example of “well-heeled and well-capitalized folks” for whom your idea might make sense, but even there I’m having difficulty working out why people who are so well-heeled (and who therefore have diminishing marginal utility of future returns) would feel the need to leverage their investments in such a manner.

I’m quite happy saying that my advice applies to at least 95% of the homeowners in the country. Yes, individual risk appetites vary, as do total savings and the like. Individuals are unique. But this is one area I feel very comfortable generalizing. Leveraging your stock-market investments with unsecured debt is dangerous; leveraging stock-market investments with secured debt is downright foolish.

Does that mean you’re foolish to borrow money against your home while still contributing to your 401(k)? Maybe not — 401(k)s are special, in terms of tax treatment, and if your employer is matching your 401(k) contributions then of course it makes sense to maximize them first. On the other hand, I do find it revealing that you borrowed specifically “for home repairs”, which are a very prudent expense, rather than for stock-market speculation.

Let’s say that you, Linda, didn’t have any home repairs this year, and that you had maxed out your 401(k). In that case, would you still have borrowed against your house, and put the proceeds in the market? I suspect not. On the other hand, let’s say you were buying your house. In that case, would you follow your own advice and put as little money down as possible, leaving the rest for investment in the market? If so, then I’m detecting an irrational inconsistency here. No?

Linda: As I’ve already said, I think the two examples — (1) someone buying a house for the first time and (2) someone refinancing a home to take money out isn’t the same thing. Alison and Brenda are two very different people! I think the person buying a home is using the leverage afforded by the low down payment to get the house in the first place. (Locking in loan, home price, beginning to build equity, saying goodbye to rent.) The person refinancing a home they already own is putting more at risk — the home — and spending money on closing costs etc. to get that investment money.

Now let me ask you a question. What about Alison, the homebuyer who has that $50,000? She could put it all down on the house, building 20 percent of equity immediately. Or she could put $8750 down, and have $41,250 left. Wouldn’t that money, invested cautiously or saved in a liquid account, better protect her from bad financial times (job loss, housing price decline, etc. etc.), than having it all tied up in the house? Again: from the homeowner’s point of view and not the bank’s.

I do think there is value, and not irrationality, in making “path-dependent” decisions, and in gradations of behavior. Taking some affordable amount of money out of home equity and investing it might make sense in some situations — such as putting it in that retirement account and that balanced mutual fund, even in the absence of home repairs. Cashing in the place where your kids sleep at night to make a big bet on Apple doubling one more time? Not so much. I didn’t recommend that kind of speculation in either of my posts.

Felix: OK, thanks Linda, I think we’ve probably wrung this one dry — although I’d point out that $41,250, if “saved in a liquid account,” is very unlikely to yield more than 4.8%.

I did promise you the last word — so, anything else you want to add before I publish this?

Linda: This has been fun and I look forward to doing it some day with wine. I think I’m done.

18 comments

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I’m sorry, we as a society have already done what Linda is advocating, and it ended badly for many. Stuff happens. People lose jobs, have a health crisis, divorce, and so on. Leverage is a risk; do you really want to risk your home against the possibility of unexpected bad stuff in the future?

Why do I think that this whole debate centers around the fact that many people, after all that has happened, still view their house primarily as an investment? It’s a place to live, folks. If you happen to make money off it, that should be a positive though unintended side-effect, not a constitutional right.

Posted by Curmudgeon | Report as abusive

Dear Felix,
You are too much of a gentleman to say this, but poor Linda does not seem to appreciate that 1+1=2 and so also 2+0=2. Framing errors are, of course, meat and drink to the behavioral economics crowd, but one hardly expects them in a professional financial adviser.

Posted by tomrus | Report as abusive

How does Reuters employ, let alone give a large and influential forum to Linda????? Her original article and her responses posted here suggest she knows about as much about (personal) finance as I do about quantum field theory or pharmacokinetics.

I read her original article and her responses here expecting her at some point to be turn around and say “oh, btw, just kidding!”

But she’s not kidding. Worse, she’s serious, and she believes (in) the ridiculous nonsense she’s saying!

I don’t think anyone with even a cursory understanding of Finance and investing would advocate the same/similar “advice” she’s throwing-out. Someone get her a copy of Seth Klarman’s “Margin of Saftey” or James Montier’s recent letter “The Seven Immutable Laws of Investing:”

1. Always insist on a margin of safety
2. This time is never different
3. Be patient and wait for the fat pitch
4. Be contrarian
5. Risk is the permanent loss of capital, never a number
6. Be leery of leverage
7. Never invest in something you don’t understand

Her “advice” ignores #’s 1, 2, 5, 6, and 7 (if not all of them). Where did Reuters dig Linda up and why the heck is she still employed? At the very-least her articles should be subject to serious review by a Financial professional before she’s allowed to publish anything, sheesh!

Her gross overgeneralization of what’s already questionable – at best – “advice” is a danger for the naive reader, of which I suspect she has many.

Posted by Anal_yst | Report as abusive

I believe Linda is confused — and thus not framing her thoughts clearly — but she does have SOME legitimate points.

(1) For an individual in the 25% tax bracket, the tax-deductible mortgage interest is effectively a LOWER rate than the yield on bonds in a tax-free account. Let’s say you earn $40k and (after $10k in taxes) have $30k left to either pay down the mortgage (saving $1440 annually in interest on a 4.8% mortgage) or put in a Roth IRA to invest in AAA bonds yielding 3.7% (interest of $1110 + $360 tax savings on the Schedule A deduction). Can explain in more detail if somebody likes, and it doesn’t really matter whether you use a Roth IRA or a conventional tax-deferred 401k.

(2) Financial flexibility is valuable. Even when paying down a mortgage is the “optimal” path, it is a highly illiquid piggy bank. In a crisis you will NOT be able to get your money back out. Thus it is very important to establish an emergency fund before you consider paying down the mortgage.

(3) If you believe that prices and/or mortgage rates are going to rise in the near future (I suspect that prices will fall but not by enough to offset the rise in mortgage rates as inflation fears kick in), then it makes sense to stretch to purchase NOW rather than delay. Risky? For sure! But with 3.5% down, your risk has limited downside.

Posted by TFF | Report as abusive

There hasn’t been any discussion of overall asset allocation. Many people have 80% or 90% of assets in one single residential house. Once emergency cash needs are taken into account, such a person would almost certainly be better off putting excess cash into stocks rather than paying down the mortgage.

Quite simply, having $30k in stocks and a $30k mortgage is safer than having no stocks, no mortgage, and 100% of your assets in your house.

Of course, by “safer” here I am talking about a medium to long term interest in overall wealth. If you only care about a place to live and plan to never sell your house no matter what, then you might be better off paying down the mortgage. But for normal folks with a high percentage of wealth in their own home, paying down the mortgage as slowly as possible usually makes sense.

Posted by john_e | Report as abusive

Felix, you’re exactly right. If there was an easy, risk-free way to earn more than the interest on your mortgage, the banks would be doing it. However, there’s not. The risk-free rate is the treasury rate. Mortgage rates are always higher than treasuries, assuming you exactly match the payment terms. Of course, there may or may not be tax-arbitrage approaches to make a very modest amount of money via a higher LTV mortgage, like TFF suggested, but Linda never talked about that, and higher LTVs add on additional expenses like PMI. Even if it is theoretically profitable, it may be the functional equivalent of picking up nickels in front of a steamroller.

Also, regarding TFF’s other two arguments: Linda doesn’t appear to be advocating financial flexibility, since she suggests taking the money and investing it in the market; and the argument about low down payments having limited downside assumes that you’re willing to strategically default on your mortgage, even though default for any reason is generally a traumatic experience for the individual homeowner.

Frankly, I find it amazing that so many people are in a rush to buy a house after the last bubble. But I guess the ability of the average person to forget recent impairment of capital is why people following Seth Klarman’s philosophy will continue to outperform amateur day traders and their ilk.

Posted by draghkhar | Report as abusive

I think what Linda’s saying here is that people who have already built up equity in a house risk a lot more by borrowing against it than people who are just about to build equity into it. Opportunities for “strategic default” are greater, for example, for the second group, because they still don’t have much equity to lose.

Posted by rogueecon | Report as abusive

I put the first graph here: http://macrobusiness.com.au/2011/03/hous e-prices-gold/

together with this graph: http://dshort.com/charts/SP-Composite-PE 10.html?SP-and-PE10
(as well as Tobin’s Q value which is very high)

and it tells me that Ms. Stern is selling snake oil along the lines of 2005.

Posted by ErnieD | Report as abusive

Good effort, Felix. You laid out the 4 scenarios in a way that a high school sophomore could understand, but the problem was that left Linda no out – you trapped her. So she faded on you…

Posted by KidDynamite | Report as abusive

I have heard Linda’s argument often. I think the reason people love that argument is because they love to mentally convert ‘consumption’ into investment. Living in a mansion is especially nice if you can convince yourself it will make your rich as well.

However, I have seen many people end up impoverished by buying too much house (the house also comes with pressure to live like the neighbors). I have seen very few who failed to get rich because they had inadequate leverage on their house. Committing to a large down payment is a good way to make sure you aren’t buying more house than you should.

The truth is, most wealthy people get that way by (a) being really good at what they do, and (b) living below their means and saving. Buying a large house isn’t going to make you any better at your job, and it isn’t going to help you save. It is at best a distraction, and at worst it is the kind of mental game that leads people to tell themselves they are investing while they are spending their way to the poorhouse.

Posted by ctbtj | Report as abusive

It is a mistake to characterize this as borrowing against your house to invest in the market. You are borrowing against your income to invest in a house and the market and accepting a risk arbitrage between housing and stocks. Put this way, you had better have a pretty good case for a stable income before you even think of buying that house and a pretty good case for an extended career before you think of continuing to do this. That is why your cases are so different. Allison is a first time buyer while Debbie is retired. It makes sense for Allison; it does not for Debbie. You do have to live somewhere but that could be renting as much as owning and no one guarantees your future rent payments either. So is that even riskier than borrowing against your home to invest? It really depends on where you are in your career, your expectations for the future, your appraisal of the where the markets are for both housing and stocks and where they are going.

Posted by MyLord | Report as abusive

Wine is on me!

Posted by lyoungny | Report as abusive

Borrowing against your house to invest in stocks is a great way for an advisor to magnify their commission earnings, but a risk that so often ends in tears. With demographic changes affecting the ratio of retired to just starting out in life and the likelihood for house prices NOT to increase in line with the past as a consequence, borrowing to invest is an even higher risk these days than it used to be.

Nice article.

Posted by FifthDecade | Report as abusive

The only thing I agree with Linda on is her last point — that it might not make sense for a homeowner to dump ALL her savings into a downpayment — that’s the rainy day fund argument, because, should a really rainy day arrive, there is every reason to believe that 95% of mortgagees will be very reluctant to allow the mortgagor to borrow against the equity in her home.

But putting the “extra” assets into a rainy day fund and investing them in the market are rather different activities. I would never do the latter: if you have a little money you are courting disaster and if you have a lot of money you don’t need to do something so risky. Kudos to you if you really feel like you know when you have “just enough” money to risk this kind of loss.

Posted by rb6 | Report as abusive

rb6, your description applies to an ideal world.

In practice, the dynamics of the tax/retirement code complicate the picture. Because both mortgage interest and retirement accounts have favorable tax treatment, it makes sense to continue retirement contributions even while carrying a mortgage. Doubly so, because retirement contribution limits prevent “lumpy” savings habits.

I wholeheartedly agree on the importance of rainy-day funds, however. You can lose your home by running out of cash. You can’t lose your home by running out of equity.

Posted by TFF | Report as abusive

I separate “retirement investing” from “normal” investing. And I am so conservative that I am not even sure I would agree that it automatically makes more sense to tie up assets in a retirement account (where tax penalties really tie them up as much as tax incentives make them desirable in the first place). It all depends on how secure you feel about your income and the price of the house you are buying. However, if the house you want to buy would prevent you from having the choice to allocate your assets between classes of investment, then maybe you need to reassess whether you are buying too much house.

Posted by rb6 | Report as abusive

“I separate “retirement investing” from “normal” investing.”

That doesn’t make much sense to me, but then I don’t have enough money for anything other than retirement investing. The money I keep outside the retirement accounts I would describe as “liquid investments” — and is largely comprised of CDs.

Guess we agree more than we differ? Any money that we have beyond what goes towards “retirement investing”, and in excess of our liquidity/emergency needs, goes towards paying down the mortgage. Only time we stopped doing that was in late 2008/early 2009 when you couldn’t lose in the stock market (and then we took that money back out over the last six months).

But I still believe that continuing retirement contributions makes more sense than stopping them for half a dozen years to pay off the mortgage more rapidly than we already are.

Posted by TFF | Report as abusive

All I can say is, “Salmon…..You ‘Nin-Com-Poop!” You have swam in the pool of artificial intelligence too long. Your mind, eyes, and heart are covered with scales and barnacles. Once those scales become so thick a fungus sets in. This causes the underneath to weep, turn red, and itch. A deep cleansing dip in the common sense pool will ease and may even cure you.
This group scrambling to be in the elitist intelligencia (this includes journalists, Republicans, Democrats and anyone else who struggles to be in the ‘high brow’ society) are infected and it is time for them to be quarantined!
My money, earned the hard way and not printed, will go to Salvation Army and Samaritan’s Purse to help the Japanese people.

Posted by ZaneT | Report as abusive