Should you take out a new mortgage or home equity line of credit and spend the money buying stocks?

The question may sound totally crazy. It's certainly not for the unsophisticated. But events in the stock, bond and mortgage markets in the past few weeks have made it a question you have to ask.

What's going on?

Mortgage rates have collapsed to unknown lows. Meanwhile the dividend yield on stocks has risen. Remember, too, that you get tax breaks on both.

Bottom line: For many people the mortgage rate is now lower than the yield on a lot of blue-chip stocks.

The gap isn't huge. But it's there. For maybe the first time in memory.

 

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You can get a 30-year fixed-rate home loan now for 4%. That's because the mortgage rate is priced in relation to the interest rate on 10-year government notes. And that interest rate has just collapsed.

The 10-year yields less than 2%, far below historic norms.

Mortgage interest in most cases is tax deductible at the federal (and often at the state) level. If you're in the upper middle class you're probably in the 25% federal tax bracket. So spending $4,000 on mortgage interest will save you $1,000 in federal taxes, and so on.

In other words, your 4% loan is really a 3% loan. (I'm ignoring Alternative Minimum Tax, and assuming you already itemize your deductions.)

Meanwhile, dividends on stocks are taxed at 15%. If a stock pays you $3.52 in dividends, you get to keep $3.

So if a stock yields 3.52% or better, and those dividends are either sustained or grow, it is offering you a better return than your cost of capital.

These are the calculations that corporations do all the time. Any project where the return on invested capital beats the cost of capital has a positive net present value.

Which stocks yield 3.52% or better?

In a word: plenty.

I ran a screen on FactSet. I looked for companies with yields over 3.5%. But I wanted to rule out companies whose dividends might be shaky. So I screened out stocks where those dividends were covered less than twice by earnings. I also screened out stocks with a market capitalization of less than $5 billion, on the theory that smaller companies may be too volatile for these purposes. Finally, for the same reason, I screened out stocks that looked expensive: Anything with a price-to-earnings ratio of 17 or more got nixed.

What was left? Fifty-nine juicy equities. And they offered a broad spread of industries. You had big telecom, likeAT&T (T) and Verizon (VZ), big pharma like Pfizer (PFE), Merck (MRK) and Eli Lilly (LLY), big defense contractors like Lockheed Martin (LMT) and Northrop Grumman (NOC) . You also had lots of utilities, such as American Electric Power (AEP), PG&E (PCG), tobacco stocks like Altria (MO) and Lorillard (LO), and even a few regular consumer names, like J.C. Penney (JCP), Campbell Soup (CPB), Darden Restaurants (DRI) and H.J. Heinz (HNZ) .

Even the Dow Jones Select Dividend Index fund (DVY), an exchange-traded fund that holds a wide basket of dividend stocks, yields 3.65%.

Note that these are only the stocks that already yield more than 3.5%. There are plenty of other top quality companies that aren't far below this level. Johnson & Johnson (JNJ) yields just under 3.5%. Chevron (CVX) yields 3.3%. So does Procter & Gamble (PG) . Pepsi Co (PEP) yields 3.2%.

Over time, dividends have tended to rise. But if you take out a 30-year fixed-rate mortgage, your interest rate won't. So there's a good chance many of these stocks will yield substantially more than 3.5% down the road.

Furthermore, throughout we're only looking at dividends, not earnings. To the extent that those earnings are productive, shareholder returns over time ought to be higher than just the dividend yield.

Naturally, this isn't for the faint-hearted. You could borrow money against your home equity and buy stocks, only to see them fall in price. Proceed at your own risk.

Companies do this all the time. Right now many of them are taking advantage of low interest rates and apparently low stock prices to borrow as much as they can in the bond market and use the money to buy back shares. In a sense, you're just "securitizing" your stock portfolio.

That you can do this at all makes me think either that many stocks are too low - or that interest rates are.