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Dr. Don, I'm looking for some advice. I bought a home a year ago and paid cash as the interest rates seemed too high. Now it appears that one could borrow against the property and make a fixed income investment that would provide some incremental return. I live in Nevada where there is no state income tax. I have considered a bond mutual fund, but the variation in income looks too dicey. A broker suggested putting together a portfolio of insured muni bonds. What do you think? The house is not part of my current living needs, which are covered with a small pension and investment income that seems to run about $100,000/year. The house is currently worth about $420,000. Thanks in advance, D.J.


This question comes up in a lot of different ways from investors all the time. They are looking to parlay the investment in their home into an investment in the financial markets. For most of us, our personal residence is the largest single investment we have. Where we buy, what we buy and how we finance that investment is very important to our financial health.

Your broker is referring to municipal bonds, or munis for short. If you invest in municipal bonds, the interest income is exempt from federal income taxes and, when held by citizens of the state where the bonds are issued, the interest income is typically exempt from state income tax as well. (There are some exceptions, like Iowa, Oklahoma and Wisconsin, where their residents pay state income tax on most municipal bonds issued in those states.)

What he's suggesting is that you make an arbitrage play by borrowing against your home's equity and investing in insured municipal bonds. If your after-tax cost of debt is less than your after-tax return on the munis, you've created a riskless, or virtually riskless, profit on the transaction.

But there's a lot of I's to dot and T's to cross to make this work. First, you need to be able to take advantage of the interest-expense deduction on your federal taxes. See

IRS Publication 550 --

Investment Income and Expenses

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for more information on the tax deductibility of this interest expense. You also need to consider how closing costs will impact the effective cost of borrowing the money. Finally, you have to be sure not to invest in municipal bonds whose interest is subject to the alternate minimum tax. My colleague

Elizabeth Roy

provides additional

detail about municipal bonds' tax.

Is there going to be enough spread in the transaction to make it viable? If your after-tax return on your muni portfolio is 5.25% and your after-tax cost of debt is 4.5%, then your spread is 0.75%. Assuming an 80% loan-to-value on your $420,000 home, you would have a $336,000 mortgage. In your first year, you would earn about $2,500 more than your mortgage interest expense, and that ignores the cash-flow considerations in the transaction.

First of all, you'll have a monthly mortgage payment to make, and the transaction costs associated with matching the cash flows in the muni portfolio to the cash flows required by the mortgage will be onerous and will reduce the effective yield on the muni portfolio. In other words, if you have to match the cash flows, you're not going to get the spread and the $2,500 isn't a sure thing after all.

An insured muni has minimal risk as to the loss of principal, but that doesn't mean that its price can't fluctuate with changing interest rates. If you have to sell a security, you could realize a loss on the investment. That's one of the details in trying to match the cash flows. Municipal markets also aren't as price-efficient as the U.S. Treasury market, making transactions fairly expensive.

Taking out the loan and using the money to invest in the stock market or bond market should improve the spread between what you earn in investment returns and what you pay in interest expense, but there will be a lot more risk in the portfolio. Your comment that investing in a bond fund would be too dicey makes me think that you would be unwilling to take on that risk.

Dr. Dr. Don Taylor has been an investment professional for nearly 15 years, most recently as the treasurer for a nonprofit organization where he managed more than $300 million in assets. He is a chartered financial analyst, holds a Ph.D. in finance and has taught investment and personal finance courses at the University of Wisconsin and at Florida Atlantic University. Dr. Don's Portfolio Rx aims to provide general investing information. Under no circumstances does the information in this column represent a recommendation to buy or sell. Dr. Don welcomes your inquiries and feedback at .