Dear Dr. Don,
Would it be wise to obtain a $100,000 home equity line of credit with an interest rate of 4.5 percent and then use the cash to max out our 401(k) contributions over the next three years or so? That would be $17,000 per person per year. I see two potential advantages. First, I can likely earn a higher return in a stock index fund over the long run than the home equity line of credit interest rate. Second, the contribution would bring our adjusted gross income down. If we weren’t paying the alternative minimum tax, we would also be able to deduct the interest expense from the home equity line of credit, or HELOC.
— T. Lever
You are suggesting an aggressive approach to retirement savings, one I wouldn’t recommend for most people. You would use leverage on your home to invest in the stock market through a tax-advantaged retirement account.
One could say this is based on the “cash is fungible” school of finance. It holds that all dollars are essentially the same. That’s not necessarily true in this case because deferred wages have a different tax impact than the draw from the HELOC. It would be a good idea to ask your tax professional about the implications of such a decision.
The suggested approach was popular about a decade ago among high net worth investors. HELOCs were then priced at the prime rate of interest but are relatively more expensive now. As this is written, the prime rate of interest is 3.25 percent, where it’s been since January 2009. During the early 2000s, prime ranged from a low of 4 percent to a high of 9.5 percent, according to Federal Reserve data.
My quick look yields a sobering finding about the 2000-2004 period. For 33 of the 60 months reviewed, the monthly return on the Standard & Poor’s 500 index was less than the prime rate as expressed as a monthly interest rate, or prime divided by 12. I didn’t include the dividend yield on the S&P 500 in the comparison, but it points to the risk of your strategy. Stock markets don’t always go up, but the interest expense remains the same.
Does the expected stability in the prime rate over the next couple of years mean this time is different? Legendary investor Sir John Templeton has said, “The four most dangerous words in investing are: this time it’s different.” You’d pay 1.25 percent over the prime rate for your HELOC, and the rate is variable. Even if you can deduct the mortgage interest, you’d still face a higher bar when comparing expected after-tax investment returns.
Solutions for personal finance can vary among individuals. Attitudes toward risk differ, just like investment goals and planning horizons. What’s right for you might not be right for me. I wouldn’t do what you’re suggesting. That doesn’t mean that the strategy can’t work for you. Just be careful and remember my words.
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