If you own a house, you probably receive the same junk mail that stinks up my mailbox. The aim of these junk mailers often is to wheedle you into refinancing your house. Whether or not people are reading these unwanted solicitations, plenty of homeowners have taken advantage of low-interest rates to refinance their home loans or obtain equity credit lines.
This column, however, isn't going to explore the pros and cons of refinancing. What I'm interested in examining today is what all too many people are doing with their money after they've refinanced.
An increasing number of flush homeowners are pillaging their home equity to place bets in the stock market. With a sizable stash of money to play around with, they hope to emulate Warren Buffett or perhaps Jim Cramer, the hyperkinetic host of a CNBC stock trading show. These investors hope they can make profits on their homesteads by capturing returns that dwarf the rate they're paying on their borrowed money.
People who play the market by risking their houses are more common than you may imagine. A study conducted by the Federal Reserve Board determined that 11 percent of the cash freed up through mortgage refinancing was used to invest in the market. Researchers examined a period from 2001 to the first half of 2002, but a strong argument could be made that the percentage is now higher because of the strength of the refinancing boom and soaring home values.
The Federal Reserve documented that homeowners weren't as tempted to stray into the markets just a few years earlier. From 1998 to the first half of 1999, less than 2 percent of the cashed-out equity ended up in the stock market.
It's not hard to think of reasons why you should avoid exchanging your home equity for a pile of poker chips. When investors are under pressure to generate a fat return that will justify their risky venture, they are often more inclined to assume greater risks. They may sink the money into investments that are the equivalent of sticks of dynamite with faulty fuses. Sure, riskier investments offer the potential of greater rewards, but they can also explode and obliterate your financial security.
What some gamblers also might not realize is this: When you use home equity to buy stocks, bonds or other securities, you are investing with borrowed cash. It's like purchasing stocks on margin. Yes, your buying power is greatly enhanced, but so is your risk.
Of course, leveraged borrowing leads to the ultimate reason that this strategy is flawed: If you stumble, you could lose your house. The NASD, the securities industry regulator that issued a warning on this practice, provided an example of the trouble you can face.
A retired couple, whose house is paid off, takes out a $250,000 mortgage with a 6 percent interest rate. With monthly mortgage payments of $1,663, the couple need to earn in excess of 6 percent to make a profit.
In this case, the couple's broker steers them into a mutual fund that's averaged 12 percent returns for the past five years. Hey, what could go wrong? Well, plenty. The value of the mutual fund plummets to $200,000 in a year. The couple, counting on the fund to generate enough money to meet their monthly mortgage obligation, have nearly all their net worth tied up in this investment.
To escape this jam, they can sell a portion of the mutual fund to cover mortgage payments and hope the investment rebounds. Or they can sell their home and hope the purchase price is enough to retire the loan and pay the sale expenses.
Homeowners usually don't wake up in the morning eager to plunder their home equity. Sometimes their advisers egg them on. The motivation of these financial outsiders isn't hard to fathom. If an investor has lots of money sunk into a house, a broker or financial planner can't profit from this personal wealth.
But if the money is put into stocks, bonds, variable annuities, equity index annuities or other investments, the adviser can make money through commissions or management fees.
The NASD grew concerned enough about the potential shenanigans from its ranks to issue an investor alert earlier this year. The regulator also warned brokerage firms to make sure their brokers are certain that draining equity from a house is a suitable move for any client before they proceed. Such an analysis may include looking at whether the loan is fixed or variable, the investor's risk tolerance and overall debt burden, and whether the house will likely sustain its value. Brokers were also advised to disclose to clients that they could, in the worst-case scenario, lose their home. Such a warning should stop most sane people.
If you've encountered a problem after following a broker's recommendation to invest mortgage money, you can contact the NASD's Investor Complaint Center by visiting the regulator's Web site, www.nasd.com. On the home page, type "Investor Complaint Center" in the search function.