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I'm wondering if this investment strategy would work:

  1. I get a mortgage loan for $300K at a 3% rate (realistic for current 5-year fixed mortgage rates here in Canada).

  2. I invest the proceeds in a low-fee index fund, such as Vanguard's Total Stock Market Index.

  3. I use the interest to cover the mortgage payments, and invest the rest of the returns.

This looks like it could work. Am I missing anything?

Thanks!

  • 1
    I don't think the mortgage provider will give you the cash to use, they will generally pay the seller. Or is it different in Canada. If it was possible don't you think people would have been exploiting it and the mortgage interest rates be higher as the demand for mortgages will be much higher than at present. – DumbCoder May 7 '15 at 14:22
  • If you own a home free and clear, you could use that for leverage for investing. Would you want to? – Nathan L May 7 '15 at 15:26
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    In the U.S., you can get a "second mortgage" or "home equity loan", that is, a loan that is backed by a lien on your home and where the money can be used for almost anything. So, same idea. – Jay May 7 '15 at 16:24
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    I don't know how such loans work in Canada, but here in the U.S., the cost of a mortgage is often more than the stated interest rate. There are typically "closing costs", that can range from maybe $1000 up to many thousands, on houses I've bought they've been around $5000 I think, plus if you're net equity after the loan is less than 20% you have to pay mortgage insurance, which can be another 1/4 to 1/2% or so. – Jay May 7 '15 at 16:26
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    @DumbCoder You absolutely can get a first mortgage on a house you own free and clear, and receive the proceeds to do whatever you want with. That is called a "cash out mortgage" or "cash out refinance" if there is some remaining balance on the original mortgage, and is quite common in times like this. – Joe May 8 '15 at 2:20
21

Risk is the problem, as others have pointed out.

Your fixed mortgage interest rate is for a set period of time only. Let's say your 3% might be good for five years, because that's typical of fixed-rate mortages in Canada. So, what happens in five years if your investment has dropped 50% due to a prolonged bear market, and interest rates have since moved up from 3% to 8%? Your investment would be underwater, and you wouldn't have enough to pay off the loan and exit the failed strategy. Rather, you might just be stuck with renewing the mortage at a rate that makes the strategy far less attractive, being more likely to lose money in the long run than to earn any.

Leverage, or borrowing to invest, amplifies your risk considerably. If you invest your own money in the market, you might lose what you started with, but if you borrow to invest, you might lose much more than you started with.

There's also one very specific issue with the example investment you've proposed: You would be borrowing Canadian dollars but investing in an index fund of U.S.-based companies that trade in U.S. dollars. Even if the index has positive returns in U.S. dollar terms, you might end up losing money if the Canadian dollar strengthens vs. the U.S. dollar. It has happened before, multiple times.

So, while this strategy has worked wonderfully in the past, it has also failed disastrously in the past. Unless you have a crystal ball, you need to be aware of the various risks and weigh them vs. the potential rewards. There is no free lunch.

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    A fixed-rate mortgage is a mortgage with a fixed interest rate. What you're discussing (where the interest rate adjusts after, say, 5 years) is an ARM (for Adjustable Rate Mortgage). That might be what the OP is discussing, but your terminology is off, at least as such terms are defined in the US market. – mbm29414 May 7 '15 at 21:44
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    @mbm29414 No, here in Canada, our "fixed-rate" mortgages typically have terms of 3, 5, 7, and 10 years, but most often people go for the 5-year, and that's the heavily-promoted rate lately. The amortization period is 25 years, typically, but one ends up renewing on different sets of rates over that time period. We have variable-rate mortgages which float with the prime rate, and those can adjust as often as monthly. The 15- and 30-year fixed-rate mortgages common in the U.S. are not the way the banks do it up here. No such thing. – Chris W. Rea May 7 '15 at 23:37
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    FWIW, "In Canada, the most common mortgage is the five-year fixed-rate closed mortgage. Historically in the U.S., the most common mortgage has been the 30-year fixed-rate open mortgage." See CMHC - Comparing Canada and U.S. Housing Finance Systems. (The CMHC is our version of something like Fannie Mae.) – Chris W. Rea May 7 '15 at 23:46
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    After reading up on the Canadian mortgage system, I have to say that it seems pretty odd. You guys basically have, at best, a 5-year balloon mortgage (maybe 10, but those rates get pretty high). I wouldn't buy a car that way, much less a house. There just seems to be far too much that could go wrong. Ah, well, to each their own! – mbm29414 May 8 '15 at 1:58
  • @mbm29414 Not quite a balloon mortgage. Once the five year term is up, one typically renews at then-current rates with the same lender. Sometimes folks rate-shop and switch, if the savings exceed the costs of transferring the mortage elsewhere. But, yes, it would be nice if there were a 30-year fixed mortgage product up here! – Chris W. Rea May 8 '15 at 12:48
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Well for a start funds don't pay interest. If you pick an income-paying fund (as opposed to one that automatically reinvests any income for you) you will receive periodic income based on the dividends paid by the underlying stocks, but it won't be the steady predictable interest payment you might get from a savings account or fixed-rate security.

This income is not guaranteed and will vary based on the performance of the companies making up the fund.

It's also quite likely that the income by itself won't cover the interest on your mortgage. The gains from stock market investment come from a mixture of dividends and capital growth (i.e. the increase in the price of the shares). So you may have to sell units now and again or cover part of the interest payments from other income.

You're basically betting that the after-tax returns from the fund will be greater than the mortgage interest rate you're paying.

3 facts:

  1. In the long term it is likely, but not certain, that a decent fund will return more than your mortgage rate.
  2. In the short term stock market returns are volatile - dividends and stock prices can fall leaving you with less than you started with.
  3. The mortgage has to be paid every month regardless of 2.

If you're comfortable with these 3 facts, go for it. If they're going to keep you awake at night, you might not want to take the risk.

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    Well, the Dow Select Dividend ETF happens to have a 3% yield. This is basically a free bet that these stocks will be higher 5 years hence. If in 5 years, the market drops, not due to falling earnings, but to a contraction of P/E ratios, it's possible that dividend looks like 4%, and still covers the mortgage interest. – JoeTaxpayer May 8 '15 at 12:56
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    @JoeTaxpayer It has a 3% yield now but that could rise or fall. Also is that pre- or post- any applicable taxes? And if the OP needs or wants to sell whilst the market is low they'll have to find that capital from somewhere. The cost of losing the free bet could be significant. – Nigel Harper May 8 '15 at 14:21
  • 3% is gross. In the US, our mortgages are deductible. 3% costs me 2.25%. The dividend is tax favored, so 3% nets me 2.55% return. I agree with you. It's not a slam dunk. And I actually would not recommend it. Those who did this in 2009-11 would have fared very well. The risk is far higher today. – JoeTaxpayer May 8 '15 at 15:17
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Risk. That's it. No guarantees on the fund performance, while the mortgage has a guaranteed return of -3%. I'm doing this very thing. Money is cheap, I think it's wise to take advantage of it, assuming your exercise proper risk management.

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Something very similar to this was extremely popular in the UK in the late 1980s. The practice has completely vanished since the early 2000s. Reading up on the UK endowment mortgage scandals will probably give you an excellent insight into whether you should attempt your plan.

Endowment mortgages were provided by banks and at their peak were probably the most popular mortgage form. The basic idea was that you only pay the interest on your mortgage and invest a small amount each month into a low fee endowment policy. Many endowment policies were simply index tracking, and the idea being that by the end of your mortgage you would have built up a portfolio sufficient to pay off your mortgage, and may well have extra left over.

In the late 1990s the combination of falling housing market and poor stock performance meant that many people were left with both the endowment less than their mortgage and their house in negative equity.

1

Essentially, what you're describing is a leveraged investment. As others noted, the question is how confident you can be that (a) the returns on the investment will exceed what you're paying in interest, and (b) that if you lose the bet you'll still be able to pay off the loan without severely injuring yourself.

I did essentially this when I bought my house, taking out a larger loan than necessary and leaving more money in my investments, which had been returning more than the mortgage's interest rate. I then got indecently lucky during the recession and was able to refinance down to under 4%, which I am very certain my investment will beat. I actually considered lengthening the term of the loan for that reason, or borrowing a bit more, but decided not to double down on the bet; that was my own risk-comfort threshold.

Know exactly what your risks are, including secondary effects of these risks. Run the numbers to see what the likely return is. Decide whether you like the odds enough to go for it.

protected by Community Jul 24 '15 at 15:07

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