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Leverage up?

Chris Farrell Jan 16, 2009

Question: I can tap my home equity line of credit at an interest rate of 4%. I’m thinking about using my HELOC to fund an investment in a no-load tax-free bond fund earning a dividend of 5%. The dividend income would be tax-free, and the interest expense would be tax-deductible. What are the downsides or risks to this idea? Andy, Ankeny, IA

Answer: I am consistently against individual investors borrowing to invest. Borrowing against your home to invest in the financial markets is a bad speculation. Remember, market returns aren’t guaranteed. But you will have to meet those interest payments on your loan no matter what.

We’ve gotten variations of this question over the years. Several years ago, a typical question involved taking out home equity and invest in stocks. After all, stocks have an average annual long-term return of 10% or so. Problem is, on average Lake Eerie never freezes and the stock market doesn’t plummet by more than 40%–as it did last year. The numbers always appear to work on paper, but the investment history says leveraging up (the jargon term for borrowing) is a recipe for financial trouble.

To be sure, muni yields are intriguing. Since Uncle Sam doesn’t impose a levy on muni bond interest payments. Tax exempt securities typically yield between 75% and 90% of their taxable Treasury equivalent. Yet muni’s now yield more–considerably more. For instance, the yield on a 30-year general obligation (GO) single-A+ rated muni bond is around 5.5%. (General obligation bonds or GOs are considered especially safe since they’re backed by the state’s taxing power.) For an investor in the 35% federal tax bracket that’s the equivalent of an 8.46% yield–instead of the less than 3% taxable yield on the 30 year Treasury bond.

The catch: The worst financial crisis since the Great Depression is fanning fears of widespread municipal bond defaults. Credit risk is an anathema to investors.

You want to put some risk money into a muni mutual fund? That’s fine, but tap into savings. Don’t double down on your bet.

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