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Tim Melvin

Tim Melvin is a value investor, money manager and writer. He has spent the last 27 years as in the financial services and investment industry as a broker, advisor and portfolio manager. He has also...

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Risks Associated With Tapping Home Equity To Buy Stocks

Having sprouted some gray hairs and lost more than a few others, most of us have heard some bad advice in our lifetime.

Always bet the favorite. Go all in with Ace-King. Never eat at a place called 'Mom's.' Buy stocks because they return 10 percent a year. Get a real job. Use managed futures to properly diversify a portfolio. Buy real estate because it never goes down. Buy internet stocks because they are changing the world and it's a new paradigm.

In a recent article on Benzinga, writer Jonathan Yates wrote on the reasons to tap into home equity to purchase stocks. The intention here is to dig deeper into the reasons listed in the aforementioned article and also isolate the risks involved.

The article suggests three major points as to why this might be a great idea. Let's break them down.

”It diversifies the core value of the largest asset of most Americans.”

If your home is your only investment, then this alleged diversification could expose you to a whole new form of retirement, commonly known as 'homelessness.' Exactly what set of unique market conditions would lead to other assets performing in such a manner to protect from falling home prices? If your portfolio is diversified and markets turn South, everything is going down except the loan balance on the mortgage taken to finance this idea.

This is not exactly portfolio diversification, it's increasing risk exposure.

Related: Pay Attention: The Private Equity Message To Investors

It might help to keep in mind that a home already performs diversified duties. It's an asset, and as such can move up and down with the market levels - the hope being that over a long period of time, the asset value increases as the mortgage balance decreases.

But it's more than that, isn't it? It's also your home, your residence, your shelter. It's the neighborhood with good schools for the kids. It's the community where you want to spend your golden years. One of the leading causes of the recent credit meltdown was that people treated houses as ATMs instead of homes. Now, they don't have one anymore.

It's not just an asset. It's your home.

”There are many stocks that have dividend yields higher than mortgage rates.”

Yes, many stocks currently have a dividend yield higher than mortgage rates…or do they? It looks like cash-out refinancing is going to go off at about four percent. A new home rate is not going to be noticeably better. Let's call it 3.5 percent. So now the task is to find stocks that yield more than four percent to fund this practice.

Using a stock screener, there's about 403 stocks to choose from. But since we are diversifying our assets, let's take out all the real estate investment trusts (REITs) and other real estate-related securities (the article suggest a package of higher yielding REITs, which would indicate a poor understanding of how diversification works). That brings the list down to just 302 stocks to choose from.

The closed-end bond funds and mortgage REITs also need to be removed from consideration, as these will respond to rising rates in exactly the same manner as housing. The list is now down to just 253 stocks that will fund the mortgage adventure. Almost all of them are either utilities or energy Master Limited partnerships (MLPs).

If those are taken out, the list goes down to just 145 companies that have dividend yield of more than four percent.

Now, in order to keep dividends safe, financially healthy companies that are committed to paying a dividend are needed. Let's cut the list to just those companies with Altman Z-scores of three or higher so that beyond a shadow of doubt, the company is fiscally sound. After all, if the dividend is cut or eliminated, the home equity dip doesn't make much sense.

That brings the list down to just 12 operating companies that pay dividends high enough to cover the mortgage and have balance sheets safe enough to feel secure in the payments continuing.

So in order for the home equity plan to work, the portfolio will need to consist of a bunch of oil and gas limited partnerships, REITs and utility stocks. While this may or may not be a grand idea, do you really want to bet the house (or the farm) on it?

Let's even say that there's enough companies to pay high dividends and cover the mortgage payments and engage in the interest rate arbitrage. Let's imagine a portfolio of 30 stocks or so that pay over four percent and have good feelings about this idea.

Now let's imagine that shots are fired in the Ukraine, Russia shuts off the gas to Europe and the eurozone economy collapses and over the next several months, and stocks tumble by 40 percent. Think it won't happen? Well, it has happened twice in the last 14 years.

Related: Executive Exhaustion Fuels Opportunity For Investors

”Stocks are much more liquid than real estate.”

This can actually be viewed as a great reason not to do this. It's the liquidity of stocks that leads investors to chase hot stocks and over-trade their accounts. Individual investors badly underperform the market averages because of such destructive behavior. Countless studies have documented this unfortunate fact and there would have to be a high degree of conviction on behalf of the above average investor with the discipline to stay the course.

Add in the fact that instant liquidity is overvalued. Warren Buffett once said that if he bought a stock and markets closed the next day for five years, he wouldn't care. Buying stocks is buying a piece of a business and liquidity should be the last concern. If there's a desire to be able to sell a long-lived asset instantly, it probably should not be bought in the first place.

Consider 2008 as a great example of the cost of instant liquidity. Housing was dropping in value and markets were crashing around investors' ears. Most people panicked, sold stocks and missed the subsequent recover that would have at least given them their money back by now.

Consumers could not sell their house, and as long as they didn't have one of those variable interest rate mortgages, they have seen their house values stabilize and have regained some of their equity. The fact that homeowners could not sell the asset kept them from selling at the lows. Nothing is so overvalued as liquidity in the world of long-term investing.

If you need liquidity, you have no business investing in stocks in the first place.

Justification?

The only way you could ever justify taking this advice is if you didn't need to take it in the first place. Only someone with lots of other assets can afford to take money out of their house to invest in the stock market. A young person who doesn't mind the idea of going back to apartment life with a horrid credit rating could take the long shot, but it's doubtful that many would have sufficient equity to make it worthwhile.

The "tapping home equity" plan doesn't increase diversification or allow engagement in some fanciful arbitrage that gains a free house. All it does is increase exposure to rising rates and falling markets and increases the risk level.

Live in your home. Pay down the mortgage over time. Spend less than you make. Save your money and invest excess cash in the stock market.

It's not just an asset. It's your home.

Tags: mortgage private equity reits

Posted in: Education Personal Finance General