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.