The Dogs of the Dow can help pay off your mortgage

There's a case to be made for the Dogs of the Dow, even as stocks opened 2016 down sharply — the Dow itself by as much as 400 points.

With stock market volatility expected to continue, stocks that were scorned last year are worth a look. And if stock gains are going to be broadly limited, going value-hunting among the Dogs of the Dow makes sense for two specific reasons: These are not stocks that have been pushed higher by investors. And even without great expectations for stock price gains, these companies pay dividends that are high enough to pay off the mortgage of most Americans.

The Dogs of the Dow strategy has been given new prominence — and a new twist — due to the Federal Reserve's finally raising interest rates. Mortgage rates are still so low that the dividends of blue-chip stocks can actually pay an average mortgage if an investor puts aside a little bit more than the mortgage balance.

The time-honored Dogs of the Dow investment strategy has long been used by investors to mark a new year by buying into the 10 members of the Dow Jones Industrial Average that pay the highest dividend. Right now the five highest-yielding dogs are Verizon, Caterpillar, IBM, Chevron and ExxonMobil.

Yet there are two big caveats.

One hazard of the strategy is that it requires a commitment to some of Wall Street's least-loved stocks — but that is also the promise. (In particular, it means buying some big oil stocks that could remain mired in a slump for a while).

The second big thing is that you need to be in a position to invest — if you have all you can handle financially just making ends meet month to month, the extra money to invest isn't likely to be available or prudent to try and cobble together.

"If you've got the money, you add a little risk, but you can make a point or two," said Howard Silverblatt, senior analyst at S&P Dow Jones Indices.

Here's how it would work for a $350,000 mortgage: The national average rates are 3.92 percent for a 30-year fixed loan and 3.19 percent for a five-year adjustable-rate mortgage, which is repaid over the same 30 years. The payment is $1,655 for the fixed-rate loan and $1,512 for the ARM.

At the 4.4 percent average dividend rate for the five highest-yielding Dogs, putting $350,000 of liquid assets aside and devoting the income from them to paying the mortgage generates about $1,283 a month. Throw in the tax savings — dividend income is taxed at 15 percent, while the mortgage-interest deduction saves most upper-income investors at least a quarter of the interest they pay — and it comes close to even.

Greg McBride, chief financial analyst at Bankrate.com, said, "This is but one illustration of why pouring extra money into paying down, or avoiding having to take, a low fixed-rate tax-deductible mortgage is not the optimal financial move. "Often, in fact, it limits the homeowner's financial flexibility as you can't get to money tied up in home equity if you need it."

Put another way, it makes sense to keep a mortgage — even if you can afford to pay it off — to get the tax benefit, and to have the financial flexibility of knowing the amount of cash and liquid investments you would need to pay off your mortgage is still available if you hit a rough patch, like job loss.

In the dog house

If you take all 10 dogs — adding Cisco Systems, Pfizer, Procter & Gamble, Merck and Wal-Mart Stores — you would need to put aside more money to pay the mortgage but include companies that have less difficult business challenges than, for example, the big oil stocks. Combined, the average yield of the 10 Dogs of the Dow is 3.9 percent.

ExxonMobil and Chevron have been hampered for the last year by the Wile E. Coyote–like fall in oil prices, with crude oil dropping by nearly two-thirds. Caterpillar has been hammered as exports struggle, in particular to China — a fear not likely to abate with the latest contraction news out of China on Monday sinking global markets. Caterpillar slashed jobs sales and announced a major restructuring in October as revenues are expected to be about 5 percent lower next year than in 2015, which would be the fourth straight down year — something that's never happened in the company's 90-year history.

IBM is off by double digits in the past year, and analysts project declining sales into next year. Verizon is off only 2.2 percent in the last year, making its total return, including dividends, positive.

But companies that find themselves among the Dow's dogs often get their act together relatively quickly, leading to the healthy historical performance of the once-scorned stocks the next year.

"If you've got the money, you add a little risk, but you can make a point or two." -Howard Silverblatt, senior analyst at S&P Dow Jones Indices

The stock dividend strategy also illustrates that the Fed rate hike is miles from the financial nirvana for savers that some rhetoric suggests.

The average one-year certificate of deposit rate at U.S. banks is 1.10 percent. It is likely to take years for savings rates to get anywhere near 4 percent, since most economists expect the Fed to boost the rates it controls by no more than 1 percentage point a year.

Put another way, for a household to make the median household family income of about $56,000 a year from CD interest, the household would have to put away about $5 million. To pay a $350,000 mortgage, they'd have to put aside more than $2 million. So while the $350,000 in liquid assets needed to employ the Dogs of the Dow strategy to match a mortgage might seem high, it's less of an income mountain to climb for those with money than classic savings instruments.

Silverblatt said that from a dividend perspective, this strategy can be compared to another investing approach used to match a mortgage: municipal bonds. The average national AA-rated muni pays a tax-free yield of 3.35 percent, according to FMS Bonds, a Florida-based municipal investment firm.

Recently, the Dogs of the Dow strategy has done okay.

The Dow Jones High Yield Select 10 Index, which tracks the 10 highest-yielding Dow stocks of the prior year, has presented an annual returned of 8.5 percent through the last 10 years ending in 2014 and, including dividends, eked out a gain in 2015, according to S&P Dow Jones Indices. There is an exchange-traded product based on the index — the Elements DJ High Yield Select 10.

— By Tim Mullaney, special to CNBC.com