Monday, August 3, 2009

Does It Make Sense To Use Home Equity To Invest?

Home Equity To Invest?
As a measure of how Main Street is reacting to the stock market rally, we just need to check out some of the popular forums. I recently saw in a forum that discussions about withdrawing home equity for investments is becoming a hot topic again.

I can understand the speculative fervor, after all the stock market is going gang-busters (the rally started in March and shows no sign of dying down after 16 weeks ). At this moment, money seems to be growing on trees, just plonk your money into equities and it is hard not to make money.

Clearly, investors will seek all kinds of leverage to maximise their profits during this "window" of opportunity where fundamentals don't matter. But have we already forgotten the misery from the financial crisis when some of us flirted with financial ruin while those who are more prudent also saw their hard-earned wealth decimated?

More specifically, is it wise to use a home equity loan to speculate or invest in securities? First let's understand the types of home equity loans available.

Types of Home Equity Loans

There are two types of home equity loans: term loans and lines of credit. The former is a one-time lump sum paid off over a predetermined time period, at a predetermined rate of interest.

A home equity line of credit (HELOC) sets a maximum amount for the line and lets the borrower withdraw money up to that point. The interest rate on a HELOC is usually variable and there are minimum requirements (in terms of time and amount) for paying back the principal.

Home Equity Loan Is A Gamble

As far as I am concerned, taking out home equity is a gamble, even if you sugar-coat it as a form of investment. There are risks associated with any investment, nobody can guarantee you make money or preserve your principal. And the basic rule is the higher the returns, then the risker the investment.

If your investment goes sour and you lose a substantial portion of the home equity loan, the collateral supporting the loan (house) is also compromised. That is a terrible fate if you have spent your adult lifetime amassing the equity in your house. In the worst case scenario, you could end up on the streets when you cannot make good on the loan payments as they fall due.

Before you undertake any investments, first evaluate the interest rate on your home equity loan. For example, if your rate is at 5%, then your investment must yield more than 5% or they are not worth the trouble.

One of the advantage being bandied out is that the interest you pay on your home equity loan is tax deductible, thus giving you a "theoretically" higher rate. But you have to remember that the home equity loan must be used for home improvements in order to qualify for the IRS home mortgage interest tax deduction. Using it for other purposes and then claiming that interest may get you penalized.

The next consideration is that payment for the home equity loan is most likely to be monthly. Hence, if your investments do not payout monthly, you will have to fork out home equity loan payment from somewhere else like your savings or the lump sum.

You should also make sure interest on your home equity loan is not a variable amount; if it is, you will need to watch it so that it doesn't go up high enough to wipe out your profits. With the possibility of the Federal Reserve raising the rates once the economy is on a firmer footing, this would be a concern of mine.

There are other options available if you need money to invest in stocks, and they don’t involve the risk of losing your home. However, if you are knowledgable and financially stable (able to cover your mortgage payments from salary rather than investments), the home-equity gamble might be a way to secure low-interest money to use to invest in securities.


SimplyForties said...

Well written and concise overview. Although I disagree that there is ever a good reason to use home equity to invest in the stock market, you certainly lay out all the aspects that one must consider.