We all take risks in life. In fact, great things are often accomplished by taking risks; therefore, being able to successfully manage risks in your life greatly increases the chances that taking those risks will be rewarding. In this article, we'll show you how to work with the risk and rewards surrounding your mortgage. (To keep reading about risk, see Determining Risk And The Risk Pyramid.)
Leverage and Refinancing
The purchase and financing of a home is a risk that most people take. It has historically been very rewarding. In recent years, it has become fashionable to take on additional risk surrounding homeownership by leveraging the value of a home through a cash-out refinance or home equity loan. Cash-out refinances and home equity loans allow consumers to borrow against the value of their homes. This is financial leverage - it adds an additional layer of risk to homeownership. (To find out more about purchasing a home or real estate, see Shopping for a Mortgage, Investing In Real Estate and Exploring Real Estate Investments.)
Cash-out refinance and home equity loans can be used for nearly any purpose. This discussion focuses on the risks of leveraging the value of a home to purchase assets with the goal of using those assets to earn additional income. (To read more articles on home equity loans, see Home-Equity Loans: The Costs, The Home-Equity Loan: What It Is And How It Works and The Reverse Mortgage: A Retirement Tool.)
An Institutional Approach to Asset-Liability Management
Extracting equity to make additional investments requires a thorough understanding of asset-liability management. Asset-liability management involves managing the risks associated with borrowing and investing money. Financial institutions devote a great deal of time, effort and resources to asset-liability management.
Financial institutions make profit through leverage; however, due to the possible amount of downside risk and associated externalities, financial institutions are highly regulated in the amount of leverage they can use and the risks that they can take. Most make profits by borrowing money at a certain rate and term to maturity and investing that money in financial instruments with similar maturities, low risk profiles and slightly higher expected returns than the rate at which they first borrowed money.
Others take on more risk and try to make larger profits by investing borrowed money in financial instruments with maturities longer than the term of their own borrowings, relatively higher risk profiles and higher expected returns. The higher the differences are between financial institutions' characteristics from their borrowings, the more risk they take on through financial leverage. (To learn more, see What are the risks of having both high operating leverage and high financial leverage?)
Good Practices of Asset-Liability Management
Most financial institutions use leverage to invest in bonds or other fixed-income assets. They do not typically invest in stocks (more on this later). They use two primary tools in asset-liability management: credit risk management and interest rate risk management.
Credit risk management involves assessing the creditworthiness of a bond's issuer and managing the risk of default. As a general rule, the lower a bond issuer's credit rating, the higher the expected rate of return or yield of the bond. (For more insight see, What Is A Corporate Credit Rating?)
Interest rate risk management involves managing the risk associated with the change in a bond's price as interest rates change. (There is an inverse relationship between bond prices and interest rates. As interest rates rise, bond prices fall. As interest rates fall, bond prices rise.) The most widely used measure of a bond's interest rate risk is called duration.
A bond's duration is a measure of a bond's percentage change in price as the result of a change in interest rates (usually 100 basis points). Duration is a function of a bond's weighted cash flows. Bonds with similar maturities and coupon payments (which make up a bond's cash flows) have similar durations. In general, the longer the maturity of a bond, the longer its duration and, therefore, the more its price will change with a change in interest rates. (To learn about this concept in more detail, see Advanced Bond Concepts.)
The risks of financial leverage are minimized when the duration of a financial institution's borrowings are matched with the duration of its investments. For example, a good duration match would be to borrow money through a two-year loan and to invest the proceeds in a two-year bond - the loan and the bond have similar cash flows and similar durations. A duration mismatch would be to borrow money for years and invest the proceeds in a 10-year bond - the loan would have to be renewed every two years to continue to finance the purchase of the 10-year bond, or the bond would have to be sold at the end of the two years. There is no certainty that the loan could be renewed at its original interest rate at the end of each of the two-year periods, nor is there any certainty that the bond could be sold after the first year at its original price.
In reality, most financial institutions do take some calculated credit and duration risks - otherwise it would be difficult to make profits. However, as mentioned earlier, they spend a great deal of time, effort and money managing these risks.
Leveraging the Value of a Home to Make Additional Investment
Extracting equity to make additional investments requires effective asset-liability management. A homeowner's approach to asset-liability management should not be very different from a financial institution's approach.
As is the case with financial institutions, this means that only investments in bonds and other fixed-income investments should be made. Using your home equity to invest into stocks is not good asset-liability management for the average person. There is extreme risk in leveraging the value of a home to invest in the stock market. Stock prices are too volatile. While the long-term expected return of the stock market is higher than that of bonds, the repayment requirements of a mortgage are unlikely to match the ups and downs of stock prices. At the time a repayment of a mortgage is due, the stock market could be in a selloff. This is the very time in which it would be a great disadvantage for the investor to have to sell in order to make payment on the mortgage. Selling during a market downturn limits future investment returns from an upward turn in the market, which lessens the probability that the total return on the investment will be greater than the interest paid on the mortgage.
On the other hand, the return earned when a bond is purchased and held to maturity can be known for certain at the time the bond is purchased. (Typically a bond's return is measured in terms of its yield, which is a function of its coupon payments and price. A bond's yield to maturity is a yield measurement that assumes the bond will be held to maturity.) If the yield to maturity of five-year non-callable bond is 9% and the interest rate on a fixed-rate mortgage is 6.5%, then an interest rate spread of 2.5% could be earned for five years with near certainty. For example, let's say $200,000 in home equity could be extracted through a cash-out refinance into 30-year fixed-rate mortgage at 6.5%. The $200,000 could be invested in a five-year bond with a yield to maturity of 9%. Over that five-year period, an interest rate spread of 2.5% or $5,000 annually could be earned. At the end of the five-year period, the bond would mature, and the $200,000 mortgage could be repaid.
Problems Still Exist
However, even this simplified scenario has problems. Mortgage payments must typically be made monthly, while bond payments are typically made every six months. Additionally, it is unlikely that a mortgage rate could be as low as 6.5%, while a highly rated bond would yield 9%. A bond yielding 9% would probably carry a great deal of credit risk. This scenario also ignores transaction costs and tax benefits/consequences. An analysis that incorporates the benefits and costs of refinancing an existing mortgage should be made.
Profitable financial institutions practice sound asset-liability management. Homeowners who are considering extracting equity from their homes to make additional investments must have a sound understanding of asset-liability management and the risks involved in leveraging the value of a home.
Financial institutions do not use leverage to invest in stocks; neither should homeowners. Stock returns are too volatile, and don't match the cash flows of a mortgage. Bonds held to maturity eliminate the risk of price volatility, but still present some cash flow problems.
Additionally, it would be challenging to find a a bond with a high credit rating that yields significantly more than the interest rate paid on a mortgage. There would be credit risk involved in investing in a bond with a substantially higher yield than the interest rate on a mortgage. For most people, a home represents their largest asset and their shelter - extracting equity to make investments with credit risk may not be a great idea for everyone. Tapping home equity should generally be performed by people who have significant assets other than their homes (in which the home is part of an overall portfolio). In that case, it might be advisable to leverage the value of a home to make additional investments, and only then to invest in bonds or other fixed-income investments.