Everyone's all too familiar with the impact that the
has had on millions of homeowners' finances. In an attempt to
make things easier on struggling borrowers, the Federal Reserve's
efforts to keep interest rates low have led to
lower monthly payments
and other relief for many homeowners who might otherwise have had
to give up their homes.
But low mortgage rates also give those who avoided the worst
of the financial crisis a lucrative opportunity to use their home
equity to boost their investment portfolios. Is refinancing a
mortgage to get cash out to invest a smart move, or is it playing
with fire? Let's take a closer look at the strategy and then turn
to some tips to consider.
Is leverage your friend?
The idea behind doing a cash-out refinancing with the intent of
investing the proceeds is pretty simple. With
hovering in the neighborhood of 3%, you have an opportunity to
profit if you can earn more than 3% on your investments. Given
that long-term stock returns have been much higher than 3%,
borrowing cheaply to buy higher-return investments seems like an
obvious-profit producing move. In fact, that's a strategy you
often see financial companies use, with not only
Bank of America
) and its Wall Street counterparts continuing to put leverage to
use but also more specialized companies, including mortgage REITs
American Capital Agency
(Nasdaq: AGNC) , using it as the foundation of their core
But taking on leverage exposes you to more risk. Clearly, as
we discovered during the
market meltdown four years ago
, stocks won't necessarily produce consistent positive returns.
If a situation like 2008 arises again, you could be stuck with
extra debt while having suffered losses that take away part or
all of the cash you invested.
Of course, you may get other benefits from investing. If you
divert money to a retirement account like an IRA or 401(k), then
you could boost your tax return and essentially have the IRS
finance part of your retirement. Similarly, using cash-out refi
proceeds to fund a 529 college savings account would give you
tax-free growth opportunities for money destined to send your
kids to college.
Control your risk
If you decide to use the higher-leverage strategy, you should
consider some ways you can reduce the inherent risk involved.
Here are just a few pointers to think about:
Don't confuse dividend yield with return.
You can find dozens of stocks right now that yield more than
3%. Well-known blue-chip stocks
(Nasdaq: INTC) , for instance, both pay out much more than 3%
in dividends. But obviously, problems can send those stocks
falling much more than their dividend income pays you,
especially with AT&T constantly having to spend billions on
wireless network infrastructure improvements and with Intel
struggling to catch up with its peers in the mobile market. In
choosing investments with money you get from refinancing
proceeds, just remember that losses can leave you behind.
When do you want to be debt-free?
From one perspective, the best way to use this strategy is to
lock in the lowest rate for as long a period as possible in
order to make use of cheap leverage as long as possible. But if
you're in your early 40s, the prospect of a brand-new 30-year
mortgage that you'll have to keep paying off well into your
retirement years may not be all that appealing. One solution is
to split the difference by using a 15-year mortgage. Your
monthly payments will be substantially higher, but you'll have
them paid off closer to your original time frame. That's a
middle ground you may feel more comfortable with.
Keep fees in mind.
If you can invest cheaply, then 3% is a pretty easy hurdle to
overcome. But if you pay big fees to invest, the higher net
cost increases the return you need. For instance, if you pay a
2% management fee to an investment advisor, you'll have to earn
5% returns in order to cover both your advisor's take as well
as your mortgage loan.
Remember what's at stake.
Even though the profit potential from the refi-and-invest
strategy is huge, you have to remember that if something goes
wrong, you could lose your home. That should guide the level of
aggressiveness in your investing, as the inherent risk involved
with the strategy should temper the additional aggressiveness
of investing in highly volatile stocks.
Despite these caveats, one thing is clear: Those who used this
strategy two or three years ago have earned some of the most
impressive returns in a generation. Those returns aren't likely
to repeat, but even at loftier levels, the stock market may well
deliver good enough results to make borrowing against your home
at ultra-cheap rates look smart.
Leverage is a tricky business, and no one knows it better than
Annaly Capital. The company has a history of paying huge
dividends to shareholders, but there are some crucial issues
investors have to understand about Annaly's business model before
buying the stock. Find out whether Annaly is a buy in our premium
research report on the company, in which our analyst runs through
key must-know topics about the stock as well as the future
opportunities and pitfalls of its strategy. Click here now to
claim your copy.
Tune in every Monday and Wednesday for Dan's columns on
retirement, investing, and personal finance. You can follow him
on Twitter @DanCaplinger.
Fool contributor Dan Caplinger has no positions in the stocks
mentioned above. The Motley Fool owns shares of Bank of America,
Intel, and Annaly Capital. Motley Fool newsletter services
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