The naive argument is that one can borrow a mortgage at say, 4%, and invest the money for a 10% return in the stock market, netting 6% on the “arbitrage”. But paying off a 4% mortgage is risk-free. (It is not a function of stock market returns.) The 10% market return in this example has a standard deviation of 20%, far from risk-free, based on historical market returns since 1926.
If you could find a risk-free 10% and keep the mortgage, that would be a certain 6% net and true arbitrage. But, that ain't gonna happen.
You would, in fact, earn the 6% difference in the years in which you receive the expected market return of 10%, but half of annual market returns are expected to be more than 10% and half less.
The meaning of “10% expected return with a standard deviation of 20%” is that in about two out of three years the returns will fall within the range of a 10% loss to a 30% gain (+ or - one standard deviation from the mean). That means the net return after the 4% mortgage payments will fall between a 16% loss and a 26% gain two out of three years. In 2007 to 2009, market returns fell way over to the wrong side of two-thirds of returns.
The worst financial mistake I have made in retirement (I should add “so far”) was taking the advice of a well-known financial planner in Washington before I retired in 2005. I could have bought my retirement home with cash, but he convinced me to hold a mortgage and leave that cash in the market. He gave me this advice because he thought the market would probably return about 10% a year on average over the life of the mortgage. But probably isn't the same as certainly and average isn't the same as annually.
Two years later, in 2007, the stock market crashed. Had I paid for the house with cash, I would have had hundreds of thousands fewer dollars exposed to the stock market.
The housing market crashed, too, but I don't plan on selling my home for a very long time, so that wasn't painful. Even the stock market crash was tolerable because I held a quite large helping of bonds. But it bugged the hell out of me that I had borrowed money against my home and paid a lot of interest for the privilege of losing that borrowed money in the stock market and that I was advised to do so by someone I trusted.
Fortunately, I could handle the losses. The former home of a good friend remains empty to this day after that housing and stock market crash. I see it every day, falling into disrepair. His mortgage was foreclosed, which brings up the most important reason I know to not borrow a mortgage to buy stocks. If you buy stocks on margin and the market crashes, you may have to sell some of your stocks and take a loss. If you buy stocks margined with your home and the market crashes, you can lose your home.
My friend had a lot of money going into 2007. It didn't seem at all likely that he would lose his home within a year.
Losing my home is high on my list of unacceptable outcomes.
I just found a 2011 article by Michael Kitces entitled Why Is It Risky To Buy Stocks On Margin But Prudent To Buy Them "On Mortgage"? This column and the comments adequately vet the issues, so I'm not going to repeat it or start a similar thread here. The issue I actually want to bring up is one of the magnitude and probability of risks.
The Retirement Income Industry Association (RIAA) describes this in perhaps the most stilted prose you can encounter. I include it here for your literary amusement:
“The diverging opinions about the value of flooring in practice may derive from the range of opinions – that cannot be proven a priori – about a practitioner’s (or a client’s) view of the primacy of the probability of failure vs. the magnitude of failure. Some believe that the probability of failure looms greater in people's minds than the magnitude of failure. Others believe that consequences always trump the odds. There is no way to tell, a-priori, who is right and who is wrong for a specific set of circumstances whose resolution and outcomes are yet ahead of us.”There. Got that?
What they're trying to say, sort of, is that at some point the consequences of failing are so horrible that “probably won't happen” is no longer good enough for some people. This is an ongoing struggle in financial planning with the “probabilities” group arguing that you can invest in stocks and you probably won't go broke and the “safety first” group countering that you should first make sure that nothing really bad is going to happen and invest what's left over in stocks.
Note that neither group says that you can't lose a whole lot of money. One side merely argues that you probably won't. The other side agrees but argues that “probably” isn't good enough when it comes to losing your standard of living in old age.
I lean toward the safety-first school. My tendency is to first take the unacceptable outcomes off the table and as I mentioned, I consider losing my home an unacceptable outcome.
I'm not against people taking financial risk in retirement. Given the difficulty involved in funding a retirement with our current system, there is no risk-free way to achieve it. I'm only against people taking risks they don't understand.
I've talked with many people who lost their homes or fortunes and not one was able to say, "I understood the risks when I took them and, if I had it to do over, I would make the same bet."
My former neighbor was a business school graduate and he could probably explain the details of his mortgage and his foreclosure risks. I'm just not sure he ever internalized that risk until it was too late.
My point isn't specifically about mortgages, or stock investments, or when to combine the two. It's about risk, both its probability and magnitude. Don't dismiss a potentially catastrophic outcome because the probability of it happening is very low.
You might go broke with a systematic withdrawals strategy, but you probably won't.
You might lose your home if you take a large mortgage and invest it in stocks, but you probably won't.
You could come up short if you claim Social Security benefits early and live to 90, but you probably won't.
The question you have to answer is when “probably won't” is good enough for you.