Many of us were taught growing up that debt was the devil. It didn’t matter what kind of debt it was – if you had debt, the best thing you could do was pay it off as quickly as possible. That’s still not the worst advice you could follow, by any stretch… but in this post, I’d like to offer another perspective on debt – specifically as it relates to debt tied to your home.

Now before we dive in here, I want to make one thing clear: I’m not offering advice here; just a perspective to give you something to chew on. Cool? Then let’s jump in 🙂

Why focus on your mortgage?

Easy – mortgages tend to have the lowest interest rates of all debt you can take out (except car loans, but we can’t touch those), and the reason for that is because the debt is tied to your home. It’s therefore a lower risk to your lender: if you don’t pay your debt, the lender forecloses your home to recover their money, plain and simple.

The reason why interest rate matters is because I want to talk about a strategy for making the equity in your home work for you… and the lower the interest rate on your debt, the harder you can make your money work.

To understand how, let’s look at an example.

Say you have a house worth $500,000, and a mortgage of $200,000 remaining on it, with an interest rate of 3%. With that mortgage, you’ll pay annual interest of just under $6,000 (it’s just under because if you’re making monthly payments, you’re paying off more principal each month).

Now, when it comes time to renew that mortgage, you could refinance and borrow back up to 80% of the value of your home – that’s an additional $200,000 in this case. But why would you ever want to do that? Shouldn’t you keep paying down your mortgage? Who wants to pay an additional $6,000 in interest every year?

Well, I personally do, and here’s why.

With that $200,000 that you’re able to draw out of your home’s equity, it’s true that you’ll pay more interest. But what if you took that money and invested it into a dividend-paying investment that averaged 7% per year? It’s not outlandish – there are plenty of options on the market.

If you did that, you could set it up so that the dividends get paid directly into the same account from which your mortgage comes out each month. In this example, you’d pay about $500 a month in interest on the extra $200,000 you borrowed… but by investing it at 7%, you’d also make $1,166 each month in dividends. That means that by borrowing that money, you’re actually coming out ahead by over $600 each month, ignoring taxes for a sec.

You can then use that to cover the increased payment you’ll have to cough up as a result of having borrowed more. In this example, you’d actually end up paying roughly the same amount out-of-pocket against your mortgage that you were before refinancing… except now you’re building double the equity that you were before. You’re building your nest egg by an extra $8,000 each year – and you’re doing it using someone else’s money. That’s powerful stuff.

Now, this isn’t for the faint of heart, which is why I’m not recommending it as advice. It takes both discipline and fortitude to make this strategy work. But it’s not as fragile as it looks. I can hear your voice on the other end of your screen saying “But what if interest rates rise? Won’t I make less?”

Yep, you will. But if you took out a fixed mortgage, your rate won’t rise during the term of your mortgage (probably 5 years, if you live in Canada). And when it comes up for renewal again, if the rate goes up so much that the gap narrows to the point where the risk is no longer worth it, you can just sell off your investments and pay off the extra money you borrowed. If interest rates are increasing that much in the economy, then it’s probably because the economy is doing well; and when the economy does well, investments tend to go up too, which means the risk of being forced to sell low is… well, low.

What’s that you say? Won’t taxes eat away at your returns? Yeah, they will. But you’ll still come out ahead – in fact, as of when I wrote this, an individual making $80,000 in Ontario would only pay 10.99% tax on dividends. That means that instead of being up $666 per month, you’d actually be up $538. That’s still over $6,000 a year extra in your pocket for investing someone else’s money.

A Word of Caution

I said it once, and I’ll say it again: this strategy isn’t for the faint of heart, and it isn’t bulletproof, either. If, by some chance, interest rates happen to rise at the same time your investment declines (or the dividend it was paying out gets cut), you could find yourself in a tough position. Only the most aggressive, risk-tolerant investors should consider the strategy, and even then, don’t jump in without doing more research.

Make sure you understand how your mortgage works, any penalties you might incur as a result of paying off a lump sum in the future, and research the investments you choose before sinking money in. You want to look for funds that invest in a variety of companies, and ideally you’d choose companies that have been around a while and stand a strong chance of being around for an extended time in the future. We’re talking the banks and the Coke and Pepsis of the world, not that sexy tech company that just issued an IPO last week.

Wrapping it Up

There’s something to be said for the peace of mind that comes with knowing that you owe no money to anyone, no doubt. But the next time someone tells you that all debt is bad, just smile and nod, because you’ll know that there are two sides to that argument. There’s money to be made for those willing to take some risk, and not all debt is bad; it’s just a matter of perspective 🙂