“I went to a financial services seminar recently where they were advising people to stop paying down the balance of their mortgage by refinancing into an interest-only loan and then invest the cash flow savings in an indexed stock fund yielding 9 percent purchased through them. What do you think of this?”

I like it a little better than the usual prescription of investing the cash flow savings in annuities. However, some borrowers can’t do it profitably because their cost of funds is too high, and others shouldn’t do it because the risks are too great.

The Best Case

Let’s assume you have a house worth $400,000, a 6 percent mortgage for $320,000, and your investment strategy is to pay off the mortgage. The monthly payment on your fully amortizing mortgage includes a principal component that reduces the balance every month. That payment of principal, which rises every month as the interest declines, is an investment that yields 6 percent with zero risk.

An alternative strategy is to convert the fully amortizing mortgage into one that is interest-only (IO), investing the cash flow savings in an indexed stock fund — a fund that holds the same stocks as those in a major stock index, such as the S&P 500. Since you will no longer be investing in mortgage repayment, this strategy is the same as borrowing at the mortgage cost in order to invest in the index fund.

Since the index is expected to yield about 9 percent over a long horizon, and assuming the cost of funds is 6 percent, you will be earning a 3 percent spread, plus tax benefits. The mortgage interest is deductible in the year paid, whereas a major part of the return on the index fund will be capital gains on which the tax rate is lower, at least today, and payment is deferred. If all goes as planned, you end up wealthier, even though you may never pay off your mortgage.

The Cost of Funds to Implement the Stock Investment Strategy

The best-case description above followed the practice of those marketing the plan of glossing over the cost of the funds invested in stocks. They assume, as I did above, that it is the rate on the refinanced mortgage, but that is wrong. If the borrower raises funds with a cash-out refinancing, the cost includes the loss of a lower-rate old mortgage (if there is one) that the borrower would have enjoyed had he kept to his mortgage payoff strategy.

For example, a borrower recently wrote me that, at the urging of his broker, he planned to raise $62,000 for investment by taking out a new mortgage for $200,000 at 6 percent, repaying the balance of $138,000 on his existing loan, which carried a rate of 4.75 percent. I told him that the cost of the $62,000 that he would invest in stocks was not 6 percent but 8.78 percent, after accounting for the increase in rate on $138,000. He had to earn 8.78 percent just to break even.

Similarly, if a borrower refinances into an interest-only loan in order to invest the cash flow savings in stocks, the cost of the cash flow includes the loss of the lower rate on the non-IO version of the mortgage that would have been used had the borrower pursued a mortgage payoff strategy.

For example, in a recent article I described a house purchaser who was considering a 30-year fixed-rate IO at 6.375 percent rather than the non-IO version at 6.25 percent, with the intention of investing the cash flow savings on the IO. I calculated the cost of those savings at 8.35 percent, after accounting for the higher rate on the IO.

If a borrower refinancing into an IO also has an existing mortgage with a low rate, the cost of funds could be well in excess of the return on stocks.

Risk and Market Volatility

An important factor to consider in assessing this investment strategy is whether you are comfortable with the risk. The expected return of 9 percent is based on experience over long historical periods, it is not promised by anyone; the actual return could be lower or higher.

Furthermore, stock prices decline as well as rise. You have to be prepared to endure periods of uncertain length during which your wealth will decline. It is not a strategy for those with short time horizons or nervous stomachs.

If you decide to go ahead, doing it on your own will avoid a host of transactions costs. Find the best available refinance deal by following the suggestions on my Web site, and find your own index fund. That is really easy to do, as you merely select the fund with the lowest expense ratio.

The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.

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