Paying Down the Mortgage vs Investing in the Market

On Saturday, I was quite

rude about a man named Richard Campbell, who wants to take out a 90% mortgage

on a house he could buy outright for cash. That’s silly: he has no reason to

believe that his investment prowess is such that his return on investment will

be higher than the interest rate on his mortgage.

Today, however, Bloomberg’s John

Wasik digs up an old piece

of research from the Federal Reserve Bank of Chicago which says that occasionally

it does make sense to invest your money and carry a larger mortgage

balance. Was I wrong?

In a word, no. The Chicago Fed report, by Gene Amromin, Jennifer

Huang, and Clemens Sialm, looks at the situation where

an individual already has a mortgage, and has the choice between paying down

principal, on the one hand, or contributing to a tax-deferred retirement account,

on the other. Sometimes, it turns out, the tax benefits of the IRA or 401(k)

more than make up for the fact that its returns can’t be expected to be higher

than the mortgage interest rate. But that’s not the situation in which Mr Campbell

finds himself: one assumes that, being a rich man, he’s already maxed out all

of his tax-free investment opportunities.

The Chicago Fed report does leave one question lingering in a tantalizing manner:

if it makes sense to contribute to an IRA rather than pay down one’s mortgage,

does that mean it also makes sense to take out a home-equity line if necessary,

in order to maximize one’s IRA contributions? The answer would seem to be yes.

What Wasik doesn’t make clear is when he starts to depart from the Chicago

Fed report and moves on to his own opinions. Here, I think he’s wrong.

As an investment, your home offers you no cash dividends or diversification,

especially if you have little in the way of stocks or bonds. Investing in

a mutual fund that packages mortgage securities, real estate, U.S. Treasuries

or Treasury inflation-protected securities reduces your dependence on the

housing market, which is in decline in much of the U.S.

I don’t see it. Let’s say that a homeowner has a $300,000 house with $150,000

left on the mortgage, which carries an interest rate of 6%. And let’s say she

has a choice between (a) paying down the mortgage by $10,000; or (b) investing

the $10,000 in a mutual fund. Fast-forward one year, and the value of the house

has dropped by 5%, while the value of the mutual fund has gone up by 5%.

In the first scenario, the homeowner paid 6% interest on a $140,000 mortgage,

for an outlay of $8,400. With the house now worth $285,000, her home equity

is $145,000. Final net position: +$136,600.

In the second scenario, the homeowner paid 6% interest on a $150,000 mortgage,

for an outlay of $9,000. Her home equity is $135,000. And her investments are

worth $10,500. Final net position: +$136,500.

In other words, even when your investments go up and your house goes down,

you’re still no better off making the investments. Or, to put it another

way, if you borrow against your house and invest the proceeds in the market,

that doesn’t reduce your exposure to the housing market.

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