The Trading Bulletin

Should You Invest Your Home Equity?

by David Berky

Question: My home is worth about $240K and we bought it 9 years ago for only $118K. If I take a home equity loan out for its full value, would it be wise to invest the amount in laddered muni bonds?  That would give me tax-free interest. I only earn about $45K per year in salary, but earned $27K from investing in bond funds last year. I need more disposable income to pay bills.

Answer:  Four things you need to consider:

1) Will the return you get on the muni bonds be greater than the interest you pay on your home equity loan?  A home equity line for up to 100% of the value of your home may have a higher than advertised rate due to the additional risk the lender takes by allowing you to borrow up to 100%.
Since you have considerable equity in your home, consider a home equity line of up to 80 or 90% of the value. (You don't have to take all the money out right away but by capping the amount at 80-90% you could receive a lower rate.)

So if your muni bonds are going to pay 5% and your home equity loan is charging you 6%, it's not a good idea.  Even a 1% profit margin may not be worth the effort when you factor in the transaction costs.

2) You may not be able to deduct the interest on your loan as "mortgage interest".  A strict reading of the IRS rules on mortgage interest in regards to home equity loans shows that unless you use the money for home improvements, the interest paid on the loan cannot be deducted as "mortgage interest".  Taking the risk of claiming that interest as a deduction is up to you.  It could get disallowed in an audit and you would have to pay taxes on the disallowed interest amount.

3) Taking the money out of your home means you are taking on additional risk when it comes to your housing, bills and job.  Should you or your wife lose your job, you will have a much larger mortgage payment than you currently have.  (Yes, the income from the muni bonds may cover your home equity
loan, but if you don't pay your first mortgage you could risk losing the house anyway.)

But you may still want to apply for a home equity loan and not use the money.  This way you have a low interest source of money to fall back on as an emergency fund in case either or both of you lose your job or have unforeseen bills (medical, legal, etc.).  This would be much cheaper than borrowing on credit cards.

4) Have you considered refinancing your home and achieving a lower payment?  If you have an interest rate above 6% and you plan on being there at least another 5 years, it is definitely worth looking into.  You could refinance your home for 30 years from now at a low rate (possibly as low as 4.5%, maybe even an interest only loan).  Because you have considerable equity in your home and if you have decent credit, you should receive the best rates available for any loan amount that is less than 80% of the loan-to-value (LTV).

For example, assuming you took out your loan 9 years ago when rates were around 8% and you took out a 95% LTV loan, you now probably owe about $99,500.  To refinance with no money down you would need to pay off the current balance plus figure in about $5000 for closing costs.  A new loan today of $105,000 at 5.5% would lower your principal and interest payment (not including taxes and insurance) from about $825/month to $600/month.  This would be like getting an extra $225/month.

Or if you borrow up to 80% of the value of your home ($192,000) at 5.5% you would increase your monthly payment by $265 to about $1090.  If you invest the extra $87,000 in muni bonds, you will need to be earning at least 3.6% to break even (see #1 above).  And consider the payment frequency on the muni bonds.  If they are not paying you a monthly amount (vs. quarterly, annually or purchased at a discount) you will have to come up with the extra cash each month either to pay the additional mortgage or to make the payments on the home equity loan.  Or you will have to budget your bond income to be able to cover the in-between months.

If an extra $225 would cover your monthly shortfall, your best bet may be to refinance.  If you need more each month and can earn more than 3.6% on the muni bonds, you could either refinance and take money out (cash-out refinance), or get a home equity loan.  (If you are paying 8% you really ought to refinance!)

In summary the thing to remember is that you need to be earning more on your investment that the borrowed money is costing you in interest.

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David Berky is president of Simple Joe, Inc., makers of easy-to-use PC software featuring the world's easiest accounting software, Income & Expenses. Visit the Simple Joe website at http://www.simplejoe.com/incomeexpenses