By Kenneth J. Burke, CPA
“Keep your money in the stock market and borrow as much as you can when buying your house.” Have you received or given this type of advice? The concept of borrowing at low cost and investing at a high rate of return seems like a simple idea and a smart financial move considering that mortgage interest continues to be tax deductible.
The general fact pattern has a nice spread between the cost of money and rate of return on the invested capital. On the surface, it’s a simple answer, “Yea, I use OPM (other peoples’ money) all the time and make money off their money”. We are really talking about a very simple leveraging concept.
This concept falls under the conventional wisdom provided from most advisors, but are we considering all the relevant facts?
Mortgage Rates Are Low
Mortgage rates are low. A 30 year fixed rate mortgage is in the neighborhood of 5.5% and a 15 year fixed rate mortgage is 5.00%. To make things even better, we get a tax deduction for the mortgage interest making the after tax cost of borrowing money even lower.
Stock Returns Are High
Not withstanding the last few months, over time the stock market returns on average approximately 10%. Generally, this return will be subject to tax at some point, hopefully at favorable long-term capital gains rates so the after tax return is less than 10%.
What About Risk?
“A concept that refines an investment's return by measuring how much risk is involved in producing that return, which is generally expressed as a number or rating. Risk-adjusted returns are applied to individual securities and investment funds and portfolios.”
“There are five principal risk measures: alpha, beta, r-squared, standard deviation and the Sharpe ratio. Each risk measure is unique in how it measures risk. When comparing two or more potential investments, an investor should always compare the same risk measures to each different investment in order to get a relative performance perspective.”
According to the website, we are admonished to consider risk when comparing two or more investments. This is exactly how we should approach the decision of borrowing money to buy a home when we have other funds invested.
Dare to Compare
I suggest considering your mortgage like an investment with a guaranteed rate of return equal to the interest rate. In the examples above, by either prepaying a mortgage or avoiding a mortgage by paying cash, you have guaranteed a return equal to 5.5% on a 30 year mortgage or 5% on a 15 year mortgage. In my opinion, this is close to a risk-free rate of return since I can’t think of much risk associated with a paid off home.
You are able to determine the risk adjusted return on your portfolio by using the ratios discussed above (Sharpe Ratio). The mix of investments will also impact the underlying risk of the portfolio so the results will vary when you have one security returning 10% vs. a diversified portfolio returning 10%. For this analysis, you may need the help of a qualified investment professional.
Make A Choice
You have two investments choices:
- Investment 1-guranteed rate of return of 5.5% (mortgage)
- Investment 2-risk adjusted rate of return of X% (portfolio)
The bottom line is the real investment gain by fully leveraging the house and keeping your cash invested is overstated if you don’t compare the returns on a risk adjusted basis. There may be an incremental benefit associated with keeping the money invested and carrying a mortgage but of course this is fact dependent.
There are several other considerations:
- How is the balance of your net worth invested?
- Is there some peace of mind with a paid off mortgage?
- What if the housing market and the stock market bubble bursts and you are exposed with a full mortgage?
- Is the tax benefit of the mortgage interest deduction all that beneficial? Remember, you have a standard deduction of $10,700 so your itemized deductions are of benefit to you at the point they exceed this threshold.
- Is your job secure?
- What is the tax cost of liquidating investments to generate the cash needed to put down on the home?
The question and answer initially seems simple. Should I max my mortgage and keep my other assets invested? The answer is slightly more complex and with full council of all the financial facts as well as the other considerations presented above you may reach a different conclusion.
Kenneth J. Burke, a certified public accountant, is a partner with Mengel, Metzger, Barr & Co. LLP. He may be contacted at Kburke@mmb-co.com.
This article originally appeared in the 01-18-08 edition of The Daily Record.
© 2008 The Daily Record
