- - Thursday, October 13, 2011

Q. My wife and I have owned our home free and clear for almost five years. It’s worth about $700,000 and we have no plans to move.

Our financial adviser says we should take out a $300,000 or $400,000 mortgage simply because interest rates are so low. He seems to think we can earn a better return in the market if we take some of our equity and invest it over the long term. He also said we should take advantage of the mortgage interest tax deduction.

Our retirement income is more than $100,000 per year and although we are very conservative with our finances, his idea appeals to us. Do you recommend the same?

A. Your financial adviser is suggesting a form of arbitrage, which basically is taking advantage of the price difference of two different markets. He is suggesting that you borrow against the equity in your home with the goal of earning a higher return than the cost of the mortgage.

I cannot recommend whether you do this or not, but it certainly is not uncommon, especially with today’s low rates. Let’s examine an example using real-life numbers.

If you have excellent credit, I see you can obtain a 5/1 adjustable-rate mortgage with an interest-only payment option with little or no fees at about 3.50 percent. A 5/1 ARM carries a fixed rate for the first five years and can adjust annually thereafter. An interest-only feature allows your payment to include only the interest charged without curtailing the loan’s principal.

Let’s say you take out a $400,000 loan with these terms. Your monthly payment to the bank would be about $1,167. Your annual interest payment would total $14,000.

If your taxable income is over $100,000, you are likely to pay at least 25 percent of your income in taxes. Assuming you itemize your tax deductions, you would have a $14,000 mortgage interest deduction, and your tax obligation would be reduced by $3,500 ($14,000 X 25 percent).

Let’s subtract the $3,500 in tax savings from your annual interest cost and the mortgage is now costing you $10,500 annually.

But you have $400,000 to invest. For you to break even, you would have to earn an annual return of at least 2.63 percent ($10,500 divided by $400,000). Can this be done? A lot of folks think so.

A quick Internet search suggests your financial adviser may be right. Let’s take a look at the actual annualized return over the last five years of the major stock indices. The Dow Jones Composite Index returned 3.40 percent and the Nasdaq Composite returned 4.28 percent. The S&P 500 index returned a measly .78 percent.

So how do the numbers play out? If your five-year investment return matches that of the Dow over the last five years, you would have $468,000 invested. But you would have paid out $70,000 in mortgage interest payments and saved $17,500 in taxes.

Over time, the equity markets tend to earn a positive return, but not without peaks and valleys. Your financial adviser is right. You very likely can earn a better return than the cost of the mortgage by investing wisely.

At the same time, you don’t want to ever get into a position where you are, for one reason or another, forced to sell or liquidate assets at the wrong time.

Send email to henrysavage@pmcmortgage.com.

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