Is It a Good Idea to Borrow in Order to Buy Stocks?

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Ask Carrie: Carrie Schwab Pomerantz - The Personal Side of Money

Is It a Good Idea to Borrow in Order to Buy Stocks?
by Carrie Schwab-Pomerantz, CFP®, President, Charles Schwab Foundation; Senior Vice President, Schwab Community Services, Charles Schwab & Co., Inc.
October 28, 2009

Dear Carrie,

I’m a 43-year-old male who bought a $300K home six years back and have it paid off completely. With interest rates so low, I’m wondering about taking out a mortgage and putting the money into the stock market where I’m more likely to get a higher return. Is this the right idea?

—A Reader

Dear Reader:

You pose an interesting question: leveraging your house to buy stocks. To help you make a decision, let's take a look at the potential benefit but also think about the risks.

The investment rationale is pretty straightforward. You have an asset that allows you to borrow cheaply. Current 30-year fixed-rate mortgages are right around 5 percent, and the interest is tax deductible. Your effective, after-tax interest rate will depend on your tax bracket, but I'd guess it would be around 3-4 percent. So the practical question is this: Can you earn more than that in the stock market?

The answer isn’t clear. Yes, stocks have historically returned around 8 percent, and many investment gurus have reduced expectations to closer to 7 percent. So if you can borrow at an effective cost of 3.5 percent and earn an average of 7 percent, that would work in your favor.

But that's looking at this decision purely from a return perspective. And as an investor, you must look at every investment decision from the potential downside as well. What are you risking if you move ahead?

When you borrow in order to invest, you're taking on risk. You would have mortgage payments to maintain, which should be fine as long as you are confident about your income. But looking at some worst-case scenarios, what if you lose your job? Or the value of your home falls? Or the stock market takes another dive? A combination of these events could put you into a very bad situation.

Now these scenarios may seem unlikely, but before you move ahead, ask yourself the following questions:

Am I prepared for emergencies? Before even considering taking on a mortgage to buy stocks, make sure you have a comfortable emergency fund: at least three to six months of living expenses. Be sure to include the amount of your mortgage. Even a year's worth of expenses in liquid assets wouldn't be overdoing it.
How secure is the value of my house? Many real estate markets may have hit bottom, but if you feel the equity in your house is on dangerous ground, borrowing to invest is probably not prudent.
How secure is my income stream? A mortgage is a long-term commitment, so before you borrow against your home, you'll have to be confident about your job security. The more comfortable you are about your income, the more comfortable you could feel about moving ahead.
Am I preparing for retirement? Finally, have you been diligent about saving for retirement? Retirement should be at the top of your priority list, so make sure that taking on a mortgage wouldn’t interfere with your ability to contribute fully to your retirement funds.

Now I realize the objections I've raised may seem extreme. But in the last year we have seen millions of people lose their jobs at the same time that they have lost their homes. Of course Investing is always about the balance between risk and reward. And if you are confident that you can afford a mortgage, your proposal could work to your benefit. Just be sure you fully understand the risks. Best of luck.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of securities and investment strategies mentioned may not be suitable for everyone. Each investor needs to review a security transaction and investment strategy for his or her own particular situation. Data contained here is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

(1009-11573)

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