You bought your dream house, you stuck to your mortgage payments and now you have some equity built up in the value of your home. But is there a way to better leverage your assets to improve your bottom line?
The answer: Yes.
Borrowing against your house to turbo-charge your retirements savings can be a great investment strategy. However, just like any financial move, you need to know if it makes the best sense for your situation.
Let’s look at the ups and downs of borrowing to invest, and why it may or may not make sense for you.
First, let’s talk about some of the conditions you’ll want to have in place before you consider this strategy. To start, you have to be willing to take on more debt in the first place. If having debt keeps you awake at night, then this definitely isn’t for you. The math is irrelevant if you’re not comfortable with debt.
Second, your mortgage should generally be less than half the value of your house. That’s because the bank will only lend you between 65% and 80% of the value of your house. So, if your mortgage already accounts for most of your house’s value, you won’t be able to borrow a significant amount against it.
Now, you may be asking why I’m only talking about borrowing against your home. That’s because for most of us, it’s the only way to get credit at a reasonable interest rate. By reasonable, I mean close to the bank’s prime rate, which is around 3.5% right now.
Third, you want to have a high and stable enough income, relative to your monthly expenses, so that you can comfortably afford the extra interest cost of carrying this new debt. I say this because in the worst-case scenario of interest rates going up while stock markets crash, you don’t want to be forced to unwind this strategy because you get pinched on your monthly cash-flow. For me, that essentially sets an upper limit for how much you want to borrow.
So, having set the stage, what does the process look like? You start by going to the bank, to see how much they’ll lend you over and above your existing mortgage.
Once the bank has confirmed how much they’ll lend you, and it’s an amount you’re comfortable with, you take the proceeds of the loan and invest it in your investment account. The investments grow over time, provided you’ve invested them in a well balanced and low-cost portfolio. Meanwhile, you make the payments on the debt.
Now make sure you track how much interest you’ve paid each year. You can deduct this interest against your income each year when you file your tax returns. This is one of the main advantages of doing this: If you’re in the top tax brackets, your interest cost essentially falls in half because you can deduct it against your income at tax time.
The benefit to you is the fact that you’re hopefully earning investment returns around 5% or 6% per year over the next 5 to 10 years, while only paying an after-tax interest rate of about 1.75%. I say 1.75% because the tax deduction gives you about half of the interest back on your tax return. So, the difference, about 3.25% to 4.25%, is what you’re creaming off the top. More simply put, for every hundred thousand dollars you borrow, you’ll be making about $3,000 to $4,000 per year.
It is really important to realize that there is no guarantee that you’ll make this amount. If markets have a bad year, you’ll have to wait for them to recover, before getting back to an average return of 5% to 6% over the period that you have this strategy in place. If markets have a great year to start, you might make more. That’s the nature of investment risk, a topic I could write a whole other post about!
