Take out home equity loan to invest in mutual funds?

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Take out home equity loan to invest in mutual funds?

Postby Growing Wiser » Tue Jan 19, 2010 5:43 am

Recently, I have been helping my brother to convert his high-cost Rollover IRA to Vanguard. And he asked me whether he should take out home equity loan to invest in mutual funds.

His situation:
(1) He has recently paid off his home mortgage;
(2) His broker friend told him that he could get 4.3% no-point interest for a home equity loan up to $400k. The cost for the loan would be close to $1k. (The interest of the loan is tax deductible.)

So the question is whether it is wise to take a certain amount of the equity loan to invest in a taxable account (such as a Vanguard account with low-cost index funds).

My thinking is: Basically, if we assume the investment gain is also taxed at the income rate for simplicity, the investment earning gain should be over the 4.3% interest rate to make some profit. Usually, 4.3% earning is considered conservative for long-term investment (e.g, over 10 years); therefore, the probability of making some profit is relatively high.

What are your thoughts about this?

Thanks a lot for your advices.
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Postby bluto » Tue Jan 19, 2010 6:08 am

If market returns and inflation hit long run averages over the next 10 years then the plan sounds fine. However stocks might stink over the next 10 years just like they did in the last 10 years.

Does your brother need to take this risk? If he is behind in his retirement savings (or other savings needs)? How large are his other assets and what would this do to him if stocks nose-dived?

Does owning his home provide him with any security? How much is that worth? He can now save his mortgage payment and not risk his home.

Bottom line, does he need to take the risk, or can he afford a bad outcome?

For me, yep, I can think of situations that I would refi to put the money to work. One year ago would have been wonderful, but I would have probably lost all my hair by March.
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Postby mfen » Tue Jan 19, 2010 6:17 am

I would never advise someone to borrow to invest in the market. If they are so keen on borrowing to invest let them come to that conclusion on their own. It is a question of risk taking, not wisdom.

If you do advise him and something goes terribly wrong with the decision he will blame you. Please just bow out graciously on this decision.
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Postby SpecialK22 » Tue Jan 19, 2010 6:50 am

Like others have posted, as long as the risks are understood your brother may be fine with taking this approach. I think it would be similar to those who choose to invest rather than pay off a mortgage; both ways you are still leveraged. I'm not entirely familiar with the tax deductible features of home equity loans so that is something else to take into consideration.
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Postby Bob's not my name » Tue Jan 19, 2010 7:04 am

You don't specify the term of the loan, whether the rate is fixed or variable, or what the repayment schedule is. Remember that if your first payment is in one month, you borrowed that money for one month at 4.3% annualized (actually more, because of the $1k fee).

You don't discuss your brother's ability to make payments if he loses his job or has another financial calamity. Such calamities may not be fortuitously coincident with market peaks.

You don't discuss DCA'ing into stock investments, which is (a) wise and (b) compatible with your brother just making a phantom mortgage payment into an index fund every month instead of borrowing money.

You don't specify that your brother is already above the standard deduction and therefore the 4.3% is entirely tax deductible (federal). You don't specify that $400k is less than the house value, which is necessary for tax deductibility. You don't discuss state tax effects.

You don't discuss your brother's AA, so respondents don't know whether he is already over-invested in stocks.

You don't specify whether "index funds" means bonds or stocks. You claim that 4.3% is conservative for 10-year investments. You should check on 10-year Treasury and 10-year CD rates. And, again, the direct comparison is only truly valid if the tax effects are perfectly symmetrical and the repayment schedule is interest-only payments and one balloon payment at 10 years.
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Postby JW Nearly Retired » Tue Jan 19, 2010 9:29 am

(2) His broker friend told him that he could get 4.3% no-point interest for a home equity loan up to $400k. The cost for the loan would be close to $1k. (The interest of the loan is tax deductible.)

You give little information to address this except that it is a very naive question. First rule of investing via a broker..... "My broker is not my friend." Repeat it over and over.

The broker is suggesting your brother mortgage his house and then the broker will sell him some high cost investments that will make the broker big fees. A bigger conflict of interest could not be imagined. Brokers are just salesmen, they don't have any strict fiduciary duty to investors at all. If the broker is suggesting this high leverage, high risk, speculation then he is for sure just looking for fees. Your brother should ditch this guy.

Of course there is a chance that the bull market will continue for a long time this would make money for your brother. So would a lucky lottery ticket. I would not bet borrowed money on either. We do know with 100% certainty that it will make money for the broker. To repeat, ditch this broker.
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Postby TheDan666 » Tue Jan 19, 2010 9:50 am

Bad Idea Jeans in my opinion.
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Postby BarbK » Tue Jan 19, 2010 10:04 am

Absolutely NOT - instead, let him invest the $ he would be paying back for the loan into the mkt. That way he will have automatic DCA...

If you have a broker, it is really much better to have them be business only not friends. No friend of mine ever steered me into a good investment.
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Postby nisiprius » Tue Jan 19, 2010 10:45 am

It's his home, for gosh sake, don't screw around with it. Whenever you have a loan with your house as collateral, there's a risk of losing that house. If the past couple of years have taught us anything, it's that losing their homes is something real that really happens to real people.

If it's a second home that he rents out for income, then, fine, its an investment and he can take whatever calculated risks seem reasonable.

This topic is frequently discussed here, for example in this recent thread. There are passionate opinions on both side. I'm agin' it.

The basic issue is that loan payment bills are 100% certain, so if whatever is going to pay those bills isn't 100% certain then there's a risk of losing the house. Investments that are safe enough just don't pay that much more than the loan. You can do tricky tax calculations until the cows come home, and, sure, sometimes there might be some advantage to it, but there just can't be a big advantage.

Now, throw psychology into the mix and ask which way people are likely to err? There's always a tendency for investors to be overconfident and to underestimate risk. And paying down debt and keeping out of debt is boring, unpleasant, and uncreative, whereas investing is interesting and exciting.

Now, throw self-interested advice bias into the mix. Let's say you are a salesman and your job is to sell investments to people. Obviously, one of the commonest objections you are going to get is "But I don't have the money." How are you going to counter that objection? Show the prospect how to get the money. If you know the prospect is a homeowner, what are you going to do? Suggest borrowing on the home, and give all the reasons why that's a smart, sophisticated, safe thing to do.

The endless supply of salespeople with investments to sell guarantees an endless supply of "borrow-to-invest" advice floating around. If not from salespeople, then indirectly from people the salespeople have convinced.

Borrowing on a home to invest is a marginal proposition, with real very-high-consequences risks, and bunch of factors that all warp judgement in the direction of overestimating benefit and underestimating risk.

Benefit: your words
if we assume the investment gain is also taxed... the investment earning gain should be over the 4.3% interest rate to make some profit. Usually, 4.3% earning is considered conservative for long-term investment (e.g, over 10 years); therefore, the probability of making some profit is relatively high.
Risk: Losing the home.
Last edited by nisiprius on Tue Jan 19, 2010 10:50 am, edited 1 time in total.
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Postby retiredjg » Tue Jan 19, 2010 10:49 am

...the probability of making some profit is relatively high.

Perhaps. But just because it is probable does not mean it will happen. More importantly, while losing his home is improbable, that does not mean it won't happen. Who would be foolish enough to risk that?

This idea is nuts. Save gambling for fun. Or for the occasional times when there is no choice and you have to gamble on something. This is not one of those times. If he has money for loan payments, he has money to invest.
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Postby fishndoc » Tue Jan 19, 2010 10:50 am

You don't discuss your brother's ability to make payments if he loses his job or has another financial calamity. Such calamities may not be fortuitously coincident with market peaks.

the most important point, IMO.

That said, if he is o/w financially stable and secure, I would consider it, as a low interest long term mortgage is an excellent inflation hedge.
However, I would only invest the mortgage money in CD's, and possibly increase my allocation to equities in my current investible portfolio.
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home leverage

Postby pkcrafter » Tue Jan 19, 2010 11:37 am

(2) His broker friend told him that he could get 4.3% no-point interest for a home equity loan up to $400k.

Broker friend is an oxymoron. No friend is going to tell someone to leverage their house against the market. He just paid off his mortgage, why would he even consider getting another one. No matter the circumstances, a home should never be involved in market risk. The obvious thing to do is for your brother to invest the money he previously used to pay the mortgage. Of course, this plan would not generate big commissions for his "friend."


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When times are good, investors tend to forget about risk and focus on opportunity. When times are bad, investors tend to forget about opportunity and focus on risk.
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Re: Take out home equity loan to invest in mutual funds?

Postby YDNAL » Tue Jan 19, 2010 11:45 am

Growing Wiser wrote:Recently, I have been helping my brother to convert his high-cost Rollover IRA to Vanguard. And he asked me whether he should take out home equity loan to invest in mutual funds.

His situation:
(1) He has recently paid off his home mortgage;
(2) His broker friend told him that he could get 4.3% no-point interest for a home equity loan up to $400k. The cost for the loan would be close to $1k. (The interest of the loan is tax deductible.)
GW,

Take previous monthly payment (1) and DCA monthly in the market - using low cost Index funds - according to a plan and asset allocation.

There... simple, without leverage, no commission to any salesman (friend or not).
Landy | Be yourself, everyone else is already taken -- Oscar Wilde
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Postby oneleaf » Tue Jan 19, 2010 11:46 am

When reading posts on the internet, the phrase "broker friend" seems to often be accompanied by bad financial advice.

It still amazes me that anyone takes financial advice from a "broker". Financial advice should be reserved for professionals qualified to give it out, or at least serious hobbyists (like the bogleheads) who have no vested interested in helping you.
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Postby Chuck » Tue Jan 19, 2010 12:00 pm

The only time I would take out a loan to invest would be if it was to fill up an available IRA contribution. For example, it's December and I can put $5,000 into an IRA or Roth IRA, but I just don't have the money right now. I would consider borrowing the money to get the IRA contribution in before the new year, if I could pay back the loan in the next six months. (The six months after that would be spent making the next year's IRA contributions.) If I couldn't pay off the loan in six months, then I'd just skip it and contribute to the IRA next year. For taxable investing, I would just say no.
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Postby ryuns » Tue Jan 19, 2010 12:21 pm

Not to derail the thread, but why is LEGAL to take out a HELOC and do anything under the sun with that money? If the interest is tax-deductible, how is ok to speculate with that money? There are restrictions on how you use student loan money, presumably because of the favorable terms on which the loan is offered. Why are HELOC's different?

(This is actually a serious question. I'm not really trying to make a point, though I find myself often exasperated by the benefits given to homeowners in this country.)

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Postby dbr » Tue Jan 19, 2010 12:22 pm

oneleaf wrote:When reading posts on the internet, the phrase "broker friend" seems to often be accompanied by bad financial advice.

It still amazes me that anyone takes financial advice from a "broker". Financial advice should be reserved for professionals qualified to give it out, or at least serious hobbyists (like the bogleheads) who have no vested interested in helping you.


Having a friend who is a broker is one of the most unfortunate and trying of life's experiences.
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Postby retiredjg » Tue Jan 19, 2010 12:58 pm

ryuns wrote:Not to derail the thread, but why is LEGAL to take out a HELOC and do anything under the sun with that money?

Come to think of it, I'm not sure it is legal. Some little bells of recognition are ringing ...., but I can't put my finger on why.
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Postby Jack » Tue Jan 19, 2010 2:00 pm

All other things equal, there is no difference between using a HELOC for investing and choosing not to pay off a mortgage and investing.

However everything is not equal. First, I think it highly unlikely you can get a HELOC at 4.3%. Second, HELOC interest rates are usually variable. The interest rate could go north at the very time your investments go south. Third many HELOCs are callable. The bank can demand payment at any time. This is most likely to occur in a financial crisis when your investments go down.
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Postby Growing Wiser » Tue Jan 19, 2010 2:20 pm

Wow. This is great! Thank you all so much for your advices.

I have showed my brother your responses and he basically gave up the idea already. Actually, the "broker friend" is his wife's and she got this idea from this "broker friend". She then asked my brother, who then asked me. My instinct is not to do it, but I am not sure I can convince him fully. So I posted the question with his consent.

I did not realize that I had not made a few points clear at that time. Although they do not matter any more, I just want to add a few clarification:

(1) the "broker friend" is a mortgage broker; my brother is going to invest by himself with the allocation I worked out with him: basically (age-15)% in bond index and the rest in stock index. (He prefers to lower his bond allocation to (age-15%) due to his assets in real estate (see (2)).)

(2) the home is a second home, which he rents out through a property-management company. This second home is worth about $650k according to Zillows. He has paid off both his primary home and this second home. (He is fortunate to have worked in a successful start up company earlier in his career.)

(3) He has always maxed out his 401k since he started working, and he has always invested in mutual funds, not single stocks. He had been paying a hefty fee for advisory services for years until I introduced him to the concepts of indexing and investing in the total markets more than a year ago and finally got him on board with it recently.

In short, he does not need to take the risk and he has decided not to do it after reading all your responses. So thank you all so much!
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Postby SamLJ » Tue Jan 19, 2010 3:39 pm

I'm glad that your brother has decided against this idea. Rather than get the HELOC the following two options would be much better:
i) DCA into the market as mentioned many times already.
ii) Sell the 2nd home and invest the money accordingly in a nice boglehead portfolio.

Edit: oops - home equity loan not HELOC...
Last edited by SamLJ on Tue Jan 19, 2010 3:53 pm, edited 2 times in total.
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Postby Bob's not my name » Tue Jan 19, 2010 3:45 pm

The OP's question was about a home equity loan, not a HELOC (home equity line of credit). Doesn't invalidate most of the responses.
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Postby Random Musings » Tue Jan 19, 2010 3:59 pm

Not a big fan of "leverage" in order to increase overall net worth.

Instead, increasing savingscan get you to the same point.

As mentioned, sounds like he didn't need to take the risk anyway. Is the phrase "broker friend" an oxymoron?

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Postby topos » Tue Jan 19, 2010 4:21 pm

I don't remember the question of borrowing from your home to invest in the stock market happening last year at the same time.
:)
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Re: Take out home equity loan to invest in mutual funds?

Postby Growing Wiser » Tue Jan 19, 2010 4:54 pm

YDNAL wrote:
Growing Wiser wrote:Recently, I have been helping my brother to convert his high-cost Rollover IRA to Vanguard. And he asked me whether he should take out home equity loan to invest in mutual funds.

His situation:
(1) He has recently paid off his home mortgage;
(2) His broker friend told him that he could get 4.3% no-point interest for a home equity loan up to $400k. The cost for the loan would be close to $1k. (The interest of the loan is tax deductible.)
GW,

Take previous monthly payment (1) and DCA monthly in the market - using low cost Index funds - according to a plan and asset allocation.

There... simple, without leverage, no commission to any salesman (friend or not).



YDNAL: Your suggestion definitely make sense. That is what my brother is going to do now. Thanks a lot.
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Postby Growing Wiser » Tue Jan 19, 2010 5:00 pm

Jack wrote:All other things equal, there is no difference between using a HELOC for investing and choosing not to pay off a mortgage and investing.

However everything is not equal. First, I think it highly unlikely you can get a HELOC at 4.3%. Second, HELOC interest rates are usually variable. The interest rate could go north at the very time your investments go south. Third many HELOCs are callable. The bank can demand payment at any time. This is most likely to occur in a financial crisis when your investments go down.


I myself have not bought a home, so I do not know much about home equity loan or HELOC. According to my sister-in-law, this "broker friend" of hers told her that they could get the loan at a fixed rate of 4.3% with no point. It can be a ten-year loan or longer. I do not know whether anything would be changed if they really sit down with this broker for the paperwork.
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Postby flyfisher_work » Tue Jan 19, 2010 5:41 pm

Why wouldn't he just DCA with what used to be the monthly mortgage payment?
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Re: Take out home equity loan to invest in mutual funds?

Postby grabiner » Tue Jan 19, 2010 10:46 pm

Growing Wiser wrote:Recently, I have been helping my brother to convert his high-cost Rollover IRA to Vanguard. And he asked me whether he should take out home equity loan to invest in mutual funds.

His situation:
(1) He has recently paid off his home mortgage;
(2) His broker friend told him that he could get 4.3% no-point interest for a home equity loan up to $400k. The cost for the loan would be close to $1k. (The interest of the loan is tax deductible.)


With a 4.3% rate, I would assume that this is a variable-rate loan; you can't get even a first mortgage at 4.3% fixed. (And I don't see why the bank would make such a loan; it could lend the same money to the US Treasury with less risk at a slightly higher rate.)

My thinking is: Basically, if we assume the investment gain is also taxed at the income rate for simplicity, the investment earning gain should be over the 4.3% interest rate to make some profit. Usually, 4.3% earning is considered conservative for long-term investment (e.g, over 10 years); therefore, the probability of making some profit is relatively high.


But this is not a correct comparison, because the probability represents a trade-off between risk and rewards. If your friend currently owns Total Bond Market Index, he could sell it and buy stock, and he would come out ahead if the stocks outperform the 3.32% yield of Total Bond Market Index. However, he has chosen not to do that because of the risk level he can tolerate.

If the HELOC is at a variable rate, that is an even worse deal.
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