We’ve seen several articles recently suggesting that it might make financial sense to take out a home mortgage or car loan at current low interest rates and invest some or all of loan proceeds in equities or other risky investments. The expectation of such Leveraged Investing is that the higher expected returns from equities will more than cover the cost of the relatively cheap loan. The same issue also applies to households considering whether they should accelerate and pay-off their mortgages or car loans vs. investing those payments in risky investments. As an example of a recent article on this subject, the February 9, 2021 Squared Away blog from the Center on Retirement Research entitled, Readers See Pros, Cons to Paid-off Mortgage, contains the following quote:
“The financial argument against paying off the mortgage was made in a blog comment by Tony Webb, a research economist at The New School. ‘At current interest rates and anticipated inflation rates, mortgage borrowing is almost free.”
Since we can’t predict future stock market returns, we can’t say one way or another whether leveraged investing will work out for you. We can say, as Conservative retired actuaries who advocate Liability-Driven Investment principles, that we aren’t likely to do it, irrespective of how “almost free” such borrowing may be. Note that this is an issue where we draw a distinction between retirees (or near retirees) and working individuals who are trying to accumulate assets for retirement (and who may be more willing to take on additional risk to achieve their savings goals).
Background
Many retirees expect to earn 5% or more per annum on their equity investments, especially over relatively long periods of time. Therefore, it may seem like a no-brainer to some to take out a loan at less than 3% interest and invest the proceeds. It is important to note, however, that returns on equities are risky and are not guaranteed, while loan repayment liabilities are fixed and guaranteed (absent declaration of bankruptcy). Therefore, while there may be an expectation that taking out a loan and investing the proceeds in equities will be profitable over the length of the loan, there is no guarantee that this will be the case. In fact, on a Risk-Adjusted basis, we see no gain to be achieved from leveraged borrowing.
Effect on Floor and Upside Portfolios
If you use Liability-Driven Investment principles and establish Floor and UpsidePortfolios to fund your future expected Essential and DiscretionaryExpenses, borrowing $X will increase the present value of your future Essential Expenses (using Conservative assumptions) by about $X and increase your investment in non-risky investments by the same $X. Therefore, your Upside Portfolio, with the higher expected returns, will be unaffected, and there will be no gain from a leveraged investment transaction.
Since loan repayments must be made, they become new Essential Expenses that you didn’t have before you took out the loan. To fund these new expected loan repayments with non-risky assets will be expensive because expected returns on the non-risky investments you use to fund these new expenses are very low, as noted by Mr. Tony Webb from The New School in the quote above.
Summary
As Conservative retired actuaries, we remain unconvinced by experts who recommend leveraged investing by highlighting the difference between the low interest rates currently available on mortgage and other loans and the higher “expected” returns on equity investments. Leveraged investing may be appropriate in today’s low interest rate environment for younger workers or for those who do not (or cannot afford) to fund their Essential Expenses with low-risk investments. We choose to stick with more Liability-Driven Investment principles.
