Securities Regulation and Litigation Lawyer & Attorney : OverRegd Blog : Lindquist & Vennum Law Firm, Minneapolis and Denver

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Due to historically low interest rates and escalating home prices, an increasing trend shows that investors are taking out new mortgages, refinancing, or obtaining line-of-credits secured by their homes for the specific purpose of investing in the market. "Betting the home" in order to invest creates unique suitability considerations. Examine the following scenario:

Jim and Shirley Jones are in their early 70s and retired. Although they owe no money on their home, they find that their monthly income falls short of meeting their daily living expenses. Their broker, Joe, suggests that they do what many other investors are doing during this economic time: borrow against the built-up equity in their home and invest the proceeds in the market. Jim and Shirley proceed to mortgage their $300,000 home at a 6 percent interest rate, using the equity they have built-up over the years to invest in a mutual fund, as Joe suggests, that has a 7-year track record of earning a 12 percent rate of return. Jim and Shirley plan to use the earnings from their investment to meet their $1,700 monthly mortgage obligation, plus have a little extra to spend as they desire.

Sound good? Yes, until the mutual fund loses money and declines in value due to market fluctuations, and the income generated from the investment is insufficient to cover Jim and Shirley's new mortgage obligations. If that occurs, Jim and Shirley - with no other available income - may be faced with two alternatives: either sell some of their depreciated investment and hope that what remains will make a dramatic come-back, or sell their home, which they once owned outright, to pay-off their mortgage and the related real estate commissions associated with the sale (assuming the market value of their home has not decreased such that the mortgage can be paid off in full).

Recognizing the extreme risks of liquefied home equity investments, the NASD in its Notice to Members No. 4-89 (Dec. 2004), alerted firms of various concerns relating to this investment procedure. The Notice cited the fact that, during the most recent review period in a Federal Reserve Board study, 11 percent of proceeds from mortgage refinancings were used for financial investments, up from less than 2 percent in the previous review period. In addition, the average amount cashed-out for investments increased from "relatively small amounts" in the earlier study to more than $24,000 in the most recent review period, which was more than nearly every other category, including home improvement.

Since investors who rely on investment returns to make their mortgage payments stand to lose more than their principal investment if the investment turns south - that is, they can lose their house, or the collateral supporting their loan -- suitability is a huge issue. In light of this, recommending firms and brokers should undergo a careful and thorough suitability analyses when determining the appropriateness of an investor's borrowing against his or home equity in order to invest. In addition to the factors typically considered, the broker's suitability analysis should include the following factors as identified in the NASD's Notice:

If an investor elects to borrow against his home equity for investment purposes, the broker's disclosure of all relevant risks and conflicts is also critical. "Best disclosure" principles, as set forth in the NASD Notice, include disclosure of the potential loss of one's home; the fact that the recommending firm, unlike other potential lenders, has an interest in obtaining loan proceeds for investments that may generate commissions or fees for the firm; the recommending firm or its affiliate may earn origination and/or servicing fees in connection with the loan; the impact of liquefied home equity on the investor's ability to refinance; and the possibility that the home value could go down which might result in negative equity in the home.

Bottom line is that cashing out home equity to invest in the market is a risky venture. Recommending firms and investors alike will be best served through the implementation of procedures that include comprehensive suitability analysis, as well as complete disclosures of all relevant risks and conflicts.