Executive Summary
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?
Though I don’t accept the premise (meaning context matters; anchors matter; framing, as you have demonstrated, matter), I do appreciate your bringing forward issues relating to what might otherwise be an unexamined orientation around leverage. I happen to be one who would (and has) been willing to borrow – particularly in the long-term fixed rate, asymmetric put-option like, subsidized manner that is available to homeowners in the United States – in order to invest more heavily in tax advantaged investment accounts. There is however a limit as to how much debt service I am able to afford; quite possibly a smaller limit on how much I am able to obtain in the terms I’ve previously described; and maybe even a smaller limit as to how much I am willing to accept. In this I suspect I am not alone, and that both planners and their clients will balk at the suggestion that if you are not willing to borrow (more than you have already outstanding) in order to invest, that you should therefore be unwilling to continue investing while you have a previously obtained balance outstanding.
Twenty or so years of working with clients – their framing, anchors, and idiosyncrasies – reminds me just how much our business is about managing people, more than it will ever be about managing their money. Agreed that you have offered a curious paradox – but with all due respect, it would be equally as questionable to advise clients to shut down all investment inflows until such time as all of their debt, including mortgage debt is paid off, as it would be to advise clients to seek a cash out refinance in order to invest the cash each time the incremental appreciation of their home allows. In the former we are accelerating the deleveraging process; in the latter we are (at least seeking to) maintaining the client’s already existing level of leverage.
Alas, if we were to frame it in this manner – in terms of deleveraging (“if you redirect money from investment inflows to accelerate paying off your mortgage, you’ll reduce your level of risk, and the potential for leverage enhanced returns; but if you borrow and reinvest as your home increases in value you’ll maintain your level of risk, and return potential) – we might just get a different answer.
Great question. I would suggest that the answer is much different for someone in retirement than someone in accumulation phase, primarily because the risk to investment accounts is magnified when you are withdrawing from them and reduced when you are contributing.
The presence of taxes in the equation complicates further. A client in a higher tax bracket could use a 5% mortgage or home equity loan to convert a portion of an IRA to a Roth, keep their bond allocation in the Roth and if the bond portfolio yield is equal to the mortgage rate (say 5% for both) he would have a pretty high level of assurance of positive after-tax arbitrage. For someone who is still working, there’s the company match to consider. In short, it should be a case by case decision, but it should always be looked at.
The simple answer for why different answers are given is cognitive dissonance (yet another casualty of the AUM model for financial planning).
For me, it is very common to have new clients pay off their mortgages and establish a $100K HELOC for emergency liquidity. You would be amazed how much happiness people derive from being mortgage free. It almost always makes their plans more robust. The main situation that we don’t do this is when all the assets are tied to a retirement account and a large withdrawal would cause taxation at a higher rate.
For younger people who are still saving, once we put enough in the 401K to get the match, I often recommend accelerating the mortgage (the fact that it is less liquid and visible helps not spend it as well).
David
Very good point, Michael. An interesting way to frame the question. I, like Don, would not be averse to recommending for a client to do a cash out mortgage to fund investments, if the facts fit, and in fact I have done it in the last few years. The reality is, however, that few clients fit the circumstances, and among those, even fewer would be comfortable with the strategy even if it was in their best interest. Even if they are equivalent, most clients would reject the idea of incurring new debt before they the idea of not retiring existing debt.
Robert,
Indeed, I agree that most clients would reject the idea of incurring new debt before the idea of not retiring existing debt. The problem is, as the illustration shows, it’s the SAME thing. They’re only different because of our irrational mental biases distorting out view.
And if the reality is that the scenarios are the same and it’s only our irrational bias that makes the difference, shouldn’t we be helping clients work through that irrationality? And shouldn’t we as planners be giving consistent advice, not something that is distorted by our own irrationality?
Respectfully,
– Michael
Michael,
I love your insights and unique perspective that you always add to the ever-evolving planning profession. In this case, I believe there are a few points that make your mortgage paradox unbalanced. First and most basic, most clients would need to initiate a HELOC on their home in order to take equity out to invest in the markets. Alternatively, they could do a cash-out refinance. Both processes are time-consuming (particularly in today’s borrowing climate) and, in the case of the HELOC, can result in an inferior variable-rate loan.
The amazing characteristic of a home loan is that it permits long-term financing with deductible interest at exrtemely low rates on an appreciating asset. Recommending to pay that kind of a powerful financing vehicle may not make good financial sense, simply because there is not better financing vehicle available in our economy. If you need to save for college, retirement, weddings, etc. our banking system and government allow you to delay paying off your home loan while you make all those other savings. But if you pay off the mortgage early and then need to borrow for any of those other scenarios you will receive inferior loan offerings. Thus, your paradox works only if you have sufficient funds to save for ALL of your long-term goals and still pay down your mortgage early.
I would also argue that believing long-term equity markets will not outperform after-tax mortgage interest rates is dangerous to long-term planning. Homes have generally appreciated at less than 6% over the long term, though that growth can be quite streaky (as we have all seen in the past decade!). Long-term equity returns have been meaningfully higher, though also streaky. If we accept the premise that equities will return less than the long-term historical average of housing, then we are fundamentally changing our expectations for world economic growth, and we have a new problem to deal with — much bigger than paying down a mortgage or not. Now we have to think about hyper-inflation and it’s effects on a portfolio, the destabilization of governments, the breakdown of the investment and banking systems: a ghastly mess, in short.
One last thought: flexibility. If I invest the hypothetical $20,000 in the markets, I can always decide to do something else with it later (though depending on my timing the amount I pull out may be less than what I put in). But if I choose to pay down the mortgage, there is no similar opportunity to redirect funds at a future date. That money is locked up in the home asset, and is very difficult to tap into, as discussed in the beginning.
So while your analysis has given me new things to think about as I consider what to recommend to clients, I don’t think the paradox is as simple and cut-and-dry as you render it. Thanks for the always great analysis and commentary!
You have noticed what psychologists call “status quo bias” – people are more likely to favor their current situation, all else equal, than one that feels new and unfamiliar, and thus, are often more comfortable with debt they already have than new debt, however irrational the preference may turn out to be.
Unfortunately, financial advisors are no less human than the rest of us and will succumb to the same biases, unless they actively try to avoid it. On the other hand, taking out a new mortgage to invest may be less tax-advantageous than keeping an existing one, especially when the amount is more than one could contribute to a retirement account in a single year.
As to your comment about investing too much into the house, I largely agree with you – and for this reason (among others), I don’t view renting as throwing money away so much as avoiding putting all your eggs in one basket. Actually, more than all your eggs in one basket. In your example the house was $500k and the client’s net worth was $200k, meaning that, get this: 250% (two hundred fifty percent) of the client’s value was in a single asset! Forget 100% stocks – how about 250% real estate?