Borrowing money to invest is a risky thing for individuals to do. While it’s a common path for businesses – borrowing money to plow into investments, infrastructure, staff, expansion, etc. – it is done in part because business structures allow for limited liability; in other words, we often borrow in business specifically because the debts cannot track back to business owners the way individual borrowing can. Accordingly, for most individuals, the only major debt that is taken at all is a mortgage to purchase a house, and only because that’s a “long term” investment (and because we couldn’t afford a house any other way); most other forms of individual debt are considered “bad” debt and only used as a necessity to be paid off quickly (e.g., credit cards or auto loans). As a result of these attitudes about debt, I’m not certain I have ever seen a financial planner tell a client “since you’re low on cash flow right now, you should take out a loan so you can have money to buy stocks in your 401(k) this year.” Tax deferral on retirement contributions aside, it’s just viewed as too risky by most to borrow money just to invest in equities in a typical investment account. There’s just one problem… by telling clients to keep their mortgages as long as possible while building their retirement accounts, we’re doing the exact the same thing: telling clients to invest in the stock market by borrowing.
To understand the paradox, let’s look at a simplified example here. Imagine you have a client with a $500,000 house and a $400,000 mortgage with a 5% interest rate, who also has only $100,000 in investment accounts; the client’s net worth is $200,000 (with $100,000 of equity in the house, and $100,000 in investment accounts). In addition, the client has managed to generate $20,000 of free cash flow by the end of the year, and asks what to do with it: he could either use the $20,000 to pay down his mortgage, or to put into his investment account (or into his 401(k)). The standard advice from most planners would be pretty straightforward: keep the mortgage as long as possible, because it’s only a 5% interest rate, while stocks have a much higher long-term average return, and save the money into the investment account for long-term growth. Had the client used the money to pay down the mortgage, he would have finished with a $380,000 mortgage and a $100,000 investment account; instead, by saving the money for growth, the client has a $120,000 investment account (and still holds a $500,000 house with a $400,000 mortgage).
So what’s the problem? Imagine if the client instead had simply come to us and said “I have a $500,000 house with a $380,000 mortgage; should I take out a $20,000 home equity line of credit at 5% to invest in stocks in my $100,000 investment account?” Almost every planner I know would say “NO!” That’s a little too risky. Keeping your mortgage is one thing, but proactively taking out debt against your house to invest in the stock market is another thing. Even FINRA has an Investor Alert out against mortgaging your house to invest in securities unless you are really comfortable with “betting the ranch” on stocks (which most seem not to be, when framed this way).
The problem is, these are still the same thing! The client in the latter scenario who takes out a $20,000 home equity line of credit to invest in the stock market finished with a $400,000 mortgage and a $120,000 investment account; the exact same result as the former scenario where the client directed cash flow to the investment account and not the mortgage principal! The only difference is the framing and the starting point: we say it’s a bad thing to “increase” debt from $380,000 to $400,000 and borrow to invest, but we say it’s a good thing to “not decrease” debt from $400,000 to $380,000 by directing cash flow to savings instead of paying down principal, even if they result in the exact same $120,000 investment account in the end (and the same overall net worth and balance sheet)!
So what’s the bottom line? If we wouldn’t tell our clients to borrow money to buy stocks in their investment account (I say stocks, because certainly we wouldn’t be buying bonds that yield less than the cost of the loan) in the first place, we probably shouldn’t be telling them to keep their mortgage and direct savings to the investment accounts, either. Yes, I realize in some cases that can lead clients to have a lot of equity in their house and not a lot in their investment accounts: but the reality is that that imbalance occurs not because they pay down their mortgage, but because they invested so much money into a real estate asset (the house) in the first place! In other words, if your clients are concerned about being “house rich” and investment-account poor, the key is not to keep the mortgage, and debt, and leverage, and risk… the key is to not put so much money concentrated into real estate assets in the first place!
In the meantime, though, the fact remains… if most clients cannot tolerate the risk (mentally, or financially) of borrowing outright against their house to invest into stocks, why aren’t we honoring that advice in the same manner by having them pay down existing debt too, even if it’s a mortgage, rather than keeping debt high and “saving” in investment accounts? (Of course, maintaining some emergency fund is another matter; I’m assuming the client keeps some reasonable amount of liquidity for basic cash flow needs.)
So what do you think? Is your advice the same for the client who is keeping an existing mortgage and putting money into investment accounts as it is for a client who wants to borrow money and increase the mortgage to invest? Should our advice be so different based only on how the question is framed, even if it leads to the exact same financial result?