Everyone's all too familiar with the impact that the housing bust 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 mortgage rates 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 (NYS: BAC) and its Wall Street counterparts continuing to put leverage to use but also more specialized companies, including mortgage REITs Annaly Capital (NYS: NLY) and American Capital Agency (NAS: AGNC) , using it as the foundation of their core business models.
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 AT&T (NYS: T) and Intel (NAS: 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.
The article Should You Bet the House on Stocks? originally appeared on Fool.com.
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 recommend Intel and AT&T. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.