Loan payments vs stock market returns

Hello All,

Thanks to EPAT, I have started applying statistics.

Here is my hypothesis, please prove me right or wrong.

Suppose loan interest rate is 2.5%, like it is in the US. 

Now I could take the loan for short term like 10 or 15years term and pay higher monthly payments.

Or I could go for 30 year term in which case I pay lower monthly and invest some money in the stock market which gives average 10% returns. At some point, the stock market gains will pay off the loan. Does this make sense? If yes, maybe I should do this as an additional assignment.

Thank you

 

for start, the burden of proof of a hypothesis is usually on the one who proposes it!



Theoretically, whenever you invest in stock market with own cash, you incur the opportunity cost of the interest rates it can earn. Assuming you can invest in 30y term and that is the best opportunity for risk-free interest, you are already, in a way, letting go that yield income to invest in equities. What you are talking about is different in one significant way though - leverage! It is not your own cash.



When you borrow the cash that you do not own and invest with it in the market, you are leveraging your investment. Such loans are very different than the 30 year mortgages. The interest rates will be much higher. Also it will not be a fixed tenor loan. You will have to roll it every day (and the lender may refuse to roll anytime). On top, it is callable - lender may ask you to top up with collaterals (margin call) or pay it back completely anytime.



This features makes it very very risky to execute this strategy. 

What if the loan is a home loan for which we can choose the term?

That is almost always illegal and a serious offence in most places.

Another article on this http://themortgagereports.com/41167/is-a-cash-out-refinance-to-invest-the-best-strategy

Even without cash out refinance, the other option I am thinking is this.

Suppose my current home loan is for a term of 15yrs with 2.75% interest rate and I pay a monthly of 3000.

If I refinance it for a 30 year term at the same rate, my monthly payment will drop to 1000. The balance 2000 per month is my money and I can invest in stock market. I calculated that if I do this for 10 years, I will not only payoff my loan but also get some decent profit.

In the first case after 15 years, my mortgage is paid off and I am left with 100% equity in my home only.

In the second case after 15 years, I can get 100% home equity and plus some equity in stocks.

 

Sir, I think you misunderstood for something else. It is not illegal.

Yes it seems I sure did. I am pretty certain using proceeds of a loan for home buying for investing in markets is illegal, as the loan is for a defined purpose. However, home equity loans (or loan against property or cash out refi) is effectively a generic loan collateralized by property. So investing that should be ok in most cases. Here the risk are different. It is still leveraged - the profits and losses are magnified. This is a long equity vs short bonds position which historically performs if you can hold up to maturity and can accept the cash flow (mismatch in interest paid and any dividends recevied) and drawdown risks. If you have a higher home equity (compared to extending maturity) you have less risks in these terms. It can also dramatically alter your portfolio allocation. Suppose you have your existing portfolio allocation at 60-40 in equities and bonds. Now if you carry out this strategy, borrowing say 30%, then the allocation becomes 90-10. This has a much higher risk profile.

It sure is risky, Thank you.