By Martin Pelletier, Financial Post, March 31, 2014 - Investors seem to have completely forgotten about the concept of risk thanks to a prolonged period of ultra-low interest and stock markets setting new highs. In particular, such an environment has a tendency to bring out the worst pieces of investment advice, such as taking out a mortgage to buy stocks.
One would think warning signs would flash when non-investment professionals such as mortgage brokers offer this type of advice. Therefore, while this may ruffle a few feathers in the industry, let’s tackle this recommendation head-on and hopefully show why it is a terrible strategy.
To begin, let’s divide your wealth into three buckets.
The first bucket contains lifestyle assets, such as your house, children’s education funds, vacation property, cars, etc., which must be protected at all costs. This means paying off any and all associated debts.
Into the second bucket go investment assets, including those that enable you to maintain your lifestyle. In many cases, this requires taking a globally diversified, pension-model approach to investing. Risk management is especially important, as these assets can often be a lifeline during periods of excessive volatility.
The final bucket contains the fun assets. This is where there can be excessive risk-taking if desired, including investing in private equity, start-ups, restaurants, etc. These can be the most satisfying types of investments when successful, but can also potentially lead to large losses.
The problem with taking out a mortgage to invest in the equity markets is that you are putting your lifestyle assets — the most important ones — at serious risk.
Suppose you have prudently just paid off all your debt. However, you listen to a mortgage broker or advisor who recommends taking out up to 75% of your $600,000 home, or $450,000, to invest in the stock market.
Say there is a mild correction of 10% in six months, which results in a $45,000 loss. This is approximately 20 months of payments in today’s current low interest environment. But you have also now taken a 7.5% hit on the equity you own in your home.
A more material correction, such as a 2008/2009 event, has a very low probability, but it’s a probability nonetheless. In this kind of scenario, you would have taken a $225,000 hit, representing more than eight years of mortgage payments.
To compound matters, your house in this latter environment will also probably fall in value. It wouldn’t be surprising to see a combined loss of nearly half the equity in your home if you had to sell it — all of those years of savings up in smoke.
For those with investments and debt, selling non-registered investments, paying off debt and borrowing to reinvest makes some sense given the ability to write off the interest expense.
However, I would take a different approach by selling these investments (likely locking in some healthy profits in today’s market) to pay off or reduce any outstanding debt and then replacing what you were paying per month to build up your investment portfolio, or bucket number two.
Finally, it is useful to take a closer look at risk like an investment professional would.
Assuming an average five-year mortgage rate of 3.5% essentially means earning a risk-free, before-tax return of just over 5.8%. This is nearly three times higher than the average five-year guaranteed investment certificate (GIC), which we think is a very fair comparison. Logic would dictate that taking a 5.8% risk-free return by paying off your mortgage is a no-brainer.
In addition, the general expectation is that interest rates will likely move higher in the years to come. Therefore, paying off low interest rate debt now frees up capital to invest in a higher interest rate environment down the road.
© 2014 National Post, a division of Postmedia Network Inc. All rights reserved.