Executive Summary Clients who need to improve their prospects for retirement generally have three options: spend less, save more, or retire later. Technically, there is a 4th option – grow faster – but it is typically dismissed due to the risk involved in investing for a higher return. In practice, clients rarely seem to dial up the portfolio risk trying to bridge a financial shortfall in retirement, and taking out a margin loan just to leverage the portfolio to achieve retirement success would most assuredly be deemed imprudent and excessively risky. Yet at the same time, a common recommendation for accumulators trying to bridge the gap is to keep any existing mortgages in place as long as possible, directing available cash flow to the investment portfolio, and giving the client the opportunity to earn the “risk arbitrage” return between the growth on investments and the cost of mortgage interest. There’s just one problem: from the perspective of the client’s balance sheet, buying stocks on margin and buying stocks “on mortgage” represent the same risk and the same leverage, even though our advice differs. Are we giving advice that contradicts ourselves?

The inspiration for today’s blog post comes from several conversations I’ve had recently with planners since my blog post a few weeks ago about how planners never tell clients to take out a loan to contribute to a retirement plan, yet willingly tell clients to contribute to 401(k) plans instead of paying down a mortgage, despite the fact that it’s comparable when looking at the entire balance sheet. In the discussions both in the comment section of the blog and offline, I began to realize we as planners have some oddly contrasting advice about debt and what is and is not risky.

For example, imagine 3 clients, who we’ll call A, B, and C. Client A has a $500,000 residence with a $500,000 fixed-rate 30-year mortgage at 5.0%, and a $1,000,000 conservative portfolio with a beta of 0.5. Client B has a $500,000 residence with no mortgage, and a $1,000,000 conservative portfolio with a beta of 0.5 that is collateral for a $500,000 variable-rate margin loan with a 5.0% interest rate. Client C has a $500,000 residence with no mortgage and a $500,000 aggressive all-equity portfolio with a beta of 1.0.

If you asked a typical planner which of these clients was the least risky, virtually all of them would answer client A, with the stable mortgage and the conservative 0.5 beta portfolio. After all, client B has a giant margin loan against his portfolio – “clearly” risky – and client C is high-risk due to the incredibly volatile portfolio being fully invested in equities with a beta of 1.0, twice that of client A.

The problem is, when you look at the impact of short-term market volatility on the client’s entire balance sheet, client A is not less risk-exposed than client B. In fact, all three clients have the exact same exposure to market volatility! To see why, let’s look first at the current balance sheet for all three clients, as shown below:

Client A Client B Client C Assets Liabilities Assets Liabilities Assets Liabilities Residence $500,000 $500,000 $500,000 Portfolio $1,000,000 $1,000,000 $500,000 Loan ($500,000) ($500,000) $0 Net Worth $1,000,000 $1,000,000 $1,000,000

As the balance sheet shows, all three clients have the exact same net worth. In addition, while Client C has a portfolio half the size of clients A and B, the portfolio has twice the volatility. Consequently, if the markets rally 10% in the near term, all three clients experience a comparable result; clients A and B grow their portfolio by 5% (since their beta is 0.5) on a portfolio of $1,000,000 and client C’s portfolio enjoys the full 10% return on $500,000. Consequently, after the rally, all three clients have a net worth of $1,050,000, as shown below (a similar $50,000 loss occurs for all three clients with a 10% market decline):

Client A Client B Client C Assets Liabilities Assets Liabilities Assets Liabilities Residence $500,000 $500,000 $500,000 Portfolio $1,050,000 $1,050,000 $550,000 Loan ($500,000) ($500,000) $0 Net Worth $1,050,000 $1,050,000 $1,050,000

In fact, any level of portfolio returns will be expressed evenly across all three of the client balance sheets, because their effective exposure is the same – client C achieves a beta of 1.0 by direct investment, and clients A and B achieve the same result by having a portfolio with half the beta and leveraging it to twice the size.

However, there are two important caveats to the scenario. The first is that in very extreme market declines, the outcomes are no longer even. While client C is limited in a market decline to losing his whole portfolio and nothing more, clients A and B could theoretically lose so much in the portfolio that there isn’t enough left to pay back the loan entirely. At that point, clients A and B can actually experience worse losses than client C; they can actually forfeit a portion of the equity in their residence to pay back the value of the loan if the portfolio falls below $500,000. Leverage has additional risk.

The second caveat is that at the end of an entire year of this process, client C is also better off – because client C doesn’t bear the cost of debt service. If we assume that the 10% market return occurs not in a short period of time, but instead over the span of a year, then at the end of the year client C has a full net worth of $1,050,000. However, client A must reduce his net worth by 5.0% x $500,000 = $25,000 of mortgage interest, and client B similarly loses 5.0% x $500,000 = $25,000 of margin loan interest. Thus, at the end of the year, client C is actually the wealthiest at $1,050,000; the other two clients only have $1,025,000! (If we assume that clients A and B pay the mortgage interest from cash flow, the result is the same, as client C would have had $25,000 of free cash flow to save and contribute to his account, producing the equivalent difference.)

In other words, “just” owning a more volatile (i.e., “riskier”) portfolio is actually the least risky way to dial up the return, superior to both buying stocks on margin or “on mortgage”! It creates greater wealth at the end of the year by saving loan interest, and eliminates the risk of a negative equity situation where the outstanding loan could exceed the value of the investment account, digging into the equity of the residence. Accordingly, this means that even if clients A and B already had a relatively aggressive portfolio, the best path for client C is still to just own even more volatile stuff in the portfolio itself; when Clients A and B have a beta of 0.5 then Client C has a beta of 1.0, but if clients A and B already have a beta of 1.0, then client C should buy small caps, emerging markets, 2x leveraged ETFs, and/or whatever else is necessary to dial up the beta to 2.0! It turns out that is still a less risky, and more cost-efficient, way to get to the retirement goal than simultaneously keeping a mortgage and an investment portfolio (or keeping a margin loan and an investment portfolio) when looking at the client’s entire balance sheet! (Of course, if the size of the loan relative to the portfolio was smaller and entailed less leverage, then client C’s portfolio wouldn’t have to be that much more volatile than the portfolios of clients A and B.)

Secondarily, it is striking that the scenario for the mortgage loan – typically viewed as a conservative route of using “good” debt – and a margin loan – typically viewed as a risky route of using “bad” debt – yield substantively identical results. For large margin loans, the interest rates are competitive, and it’s even true that both can potentially be deducted for tax purposes (as mortgage interest or investment interest, respectively) and both often utilize variable interest rates (although mortgage interest at least can be fixed). Functionally, the only real difference between the two happens to be the collateral involved; yet it’s not entirely clear offhand why buying stocks using stocks as collateral is “risky”, but buying stocks and using your home as collateral is less risky!?

Thus, it may be somewhat surprising that relative to conventional wisdom, the most prudent route to retirement success – for those who do want/need to dial up the return somehow – is to pay down the mortgage (or margin loan) out of the portfolio and dial up the volatility of the portfolio itself, rather than trying to earn the “risk arbitrage” between the portfolio return and the loan interest rate. Viewing the portfolio on its own, the former may “feel” more risky, but relative to the client’s entire balance sheet, it’s actually less risky, as it eliminates cash flow requirements, the danger of negative equity, and accrues wealth faster by also eliminating the real cost of interest. Even if that means buying a boatload of the “riskiest” high-beta stuff you can find. If the client isn’t comfortable with that level of risk, then you certainly shouldn’t invest that way – but that also means you probably shouldn’t be duplicating the effect by buying stocks on margin or “on mortgage” by keeping a giant mortgage outstanding while investing in the portfolio at the same time.

As some critics point out, this approach could potentially be very challenging to clients who wouldn’t have much of any portfolio left over if they paid off their mortgage – for instance, if it was a $1,000,000 residence with a $400,000 mortgage, and a $400,000 portfolio on the side. “Surely,” they say, “it can’t be right for a client to pay off the mortgage in this scenario; he’d had no portfolio left at all!” To which I can only reply: “If the client’s concern is that he’d be left with $1,000,000 of equity in the home and no equity in the portfolio, the problem isn’t the size of the mortgage, it’s the amount of assets the client chose to invest in real estate!” In other words, if the client doesn’t want all of his net worth tied up in a $1,000,000 piece of real estate that makes him “house rich and cash poor”… then the solution is not to borrow the equity back out via leverage, the solution is don’t buy such a huge real estate asset in the first place! (And if you do, keep a home equity line of credit open so you can borrow if there’s a real emergency that merits the borrowing risk, not as a way to leverage your portfolio!)

In the end, though, the fundamental point remains: from the perspective of the client’s entire financial balance sheet, buying stocks “on mortgage” is remarkably comparable to the risk of buying stocks on margin, which is almost (but not quite!) as risky as just investing in a portfolio that is twice as volatile in the first place. And while the last option may feel the scariest, it turns out that it’s actually the most conservative, and least expensive, route. If that’s not a comfortable level of risk in the portfolio, then a giant mortgage (or margin loan) should be a concern, too. In fact, I suspect many clients intuitively understand the implicit risk involved with mortgage debt and leverage – which is why so many people intuitively have a drive to pay down their mortgages quickly. And if the risk level isn’t comfortable, that’s actually the exact correct prescription for them, too.

So what do you think? Have you ever compared a mortgage loan to a margin loan? Or a mortgage loan to a portfolio that’s twice as volatile? Are we or our clients compartmentalizing risk by separating the loan from the investments? Is it appropriate to do so? Or should it be viewed from the perspective of the client’s entire balance sheet? Should we be telling clients to buy fewer stocks “on mortgage” and instead just invest in more volatile portfolios directly (and if they don’t want the latter, don’t let them do the former, either)?