Mortgages are a double-edged sword

Source: JONATHAN CLEMENTS of wsj.com

Mortgages are the cheapest money you will ever borrow. But if you took out a big loan that you can't afford, and are falling behind on you payments; you may lose your homes to foreclosure.

Playing the spread

If you need to borrow, you couldn't do better than a home loan, especially the adjustable-rate loan which monthly payment is often lower than the payment of fixed-rate loan.

Not only are interest rates typically lower than other types of loan, but the mortgage interest is usually tax deductible. To get a mortgage, you need to own a home or agree to buy one. But once you have that debt, the effect is to leverage all your assets. That can be highly profitable.

Suppose you have $300,000 in stocks and you want to buy a $300,000 home. You could sell your stocks and pay cash for the house. But you will likely fare better by putting, say, $100,000 of your stock money toward the house and funding the rest with a $200,000 mortgage.

Result: You control $500,000 of stocks and real estate, 40% of which ($200,000) was bought with borrowed money. As long as your assets generate higher returns than your mortgage rate, the leverage is working in your favor.

On one end, some are missing the boat

Many homeowners, however, are striving to pay down their fixed-rate mortgage quickly. Sometime they also are reducing their contributions to their employer's 401(k) or 403(b) plan.

That means these people are missing out on their 401(k)'s initial tax deduction and tax-deferred investment growth. That combination should easily outpace the interest expense they save by paying down their mortgage.

Throw in a matching employer contribution, and the 401(k) would be even more compelling.

Similarly, you could probably improve returns by taking money earmarked for extra mortgage payments and using it to fund an individual retirement account or to buy stocks in a taxable account.

Still, prepaying a mortgage can be attractive, especially if the alternative is to purchase bonds or money-market funds in a taxable account. The mortgage's after-tax interest cost is likely higher than the after-tax yield on these conservative investments.

On the other end, some are unraveling fast

Like the idea of supercharging your returns with low-cost leverage? Carry a mortgage of $300,000 for the house and you will be in control $600,000 of stocks and real estate.

But, before you take out such hefty home loan, make absolutely sure you can handle the monthly payments. Especially if you're getting an adjustable-rate loan to keep the initial mothly payments low.

Indeed, that's why I (Clements) get nervous when experts advocate getting the largest mortgage possible or recommend re-mortgaging a house to buy stocks or cash-value life insurance.

However, if the interest rate rise, you may not able to afford the larger monthly payments; things can unravel fast.

Now, if you have other savings, you could pay off a chunk of your mortgage. That should lower your monthly payment next time your mortgage rate resets.