Overview: Some investors may have the means to purchase a home with little or no mortgage needed. But is it a good idea? The following provides some items to consider regarding the home financing decision.

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Many investors have questions related to financing a home (be it the primary residence or a vacation home). One such question is whether to use investment assets in purchasing the property or to borrow the maximum. As with many questions related to investing, there is no single right answer. There are, however, important points to consider.

 

Investors may choose to invest assets in the equity market rather than spend them on their home. The main reasons for taking this approach would be a high need to take equity risk (and its associated expected return) or a significant expected difference between a low mortgage rate and a high equity premium. In other words, the relatively low after-tax cost of the mortgage compared with the possibility of large relative returns from tax-efficient equity investing can make the mortgage an attractive alternative.

 

For example, assume a mortgage rate of 8 percent. The after-tax cost for a high-bracket individual would probably be less than 5 percent. Let’s assume for illustration purposes that a well-diversified equity portfolio might be expected to return 8–10 percent in a highly tax-efficient manner (assuming the use of tax-managed funds). If such a differential were to exist, it would be tempting to remain invested in equities rather than pay off a mortgage.

 

However, it also means accepting the risks inherent to equity investing, which should not be underestimated. Also, since the equity risk premium is not constant, there are times when it may be more or less attractive to borrow and invest in equities.