For many homeowners in Canada, your home is your largest asset. While it’s hard to complain about appreciation in the value of your home, this can leave your portfolio heavily weighted in a single property that isn’t generating additional income.
In this article, let’s discuss how you can use your home to diversify your portfolio and reduce your risk without moving away entirely from the real estate sector.
The key is leverage, and it’s something you’re already familiar with if you’ve ever taken on a mortgage.
When you first purchase your home, your mortgage greatly increases the leverage ratio of your portfolio, and as long as your investments return higher than your mortgage rate, this is a smart move. As you build equity in your home over time, your leverage ratio naturally decreases, leaving you to rebalance your portfolio periodically and adjust your leverage level to meet your financial goals. If you haven’t adjusted your leverage ratio since first taking out your mortgage, now may be the time to review. It’s unlikely that you’ll have ended up with the perfect ratio of leverage without putting any thought into it.
Leveraging the equity you’ve built in your home can help you to diversify your investment portfolio and achieve your financial goals.
- Most homeowners have experience using leverage in the form of a mortgage.
- Over time as you build equity in your home, your leverage ratio decreases.
- Remember to rebalance your portfolio periodically and adjust your leverage level to fit your needs.
Your leverage ratio changes over time
With every mortgage payment you make, you are weighing your portfolio further towards real estate equity than before. When you first buy your home, you’ll likely pay somewhere in the ballpark of a 20% down payment towards the equity, giving yourself a sizable equity investment into the property. Over time, as you pay off the balance of the mortgage, your equity ownership of the property grows, and it does so even faster if you make pre-payments. On top of that if you’ve owned the property for more than a few years, it’s likely that the value of the property has appreciated as well, further adding to the concentration of real estate to your portfolio.
Your home as an asset
As a homeowner, you understand that your home is not only a valuable possession, but also a significant investment. You've likely invested a great deal of time, energy, and money into it over the years.
If you're a savvy investor, you know that it's crucial to determine how much of your net worth you want to allocate to each asset in your financial portfolio. However, as time goes on, the value of each asset will naturally fluctuate, with some high-performing assets gaining more weight in your portfolio.
Due to this, it’s important to keep an eye on your portfolio and periodically rebalance it according to your initial plan. By doing so, you can ensure that your investments are still aligned with your goals and risk tolerance. This is especially true when it comes to your home, which is likely one of your largest assets. As an investor, it's important to regularly monitor and adjust your financial portfolio to ensure that your current portfolio reflects your investment plan.
Most Canadians have the majority of their net worth tied up in their home
If you're a Canadian homeowner, it’s likely that your home is your most expensive asset. In fact, as of 2019, Canadians had over 40% of their net worth invested in real estate, with the majority of that being in their principal residence. While investing in real estate has proven to be profitable over the years, having the majority of your net worth tied up in an illiquid asset that isn't generating income may not be the best financial strategy.
While we remain optimistic about the future of Canadian real estate, it's always wise to spread your investments across multiple assets to mitigate risk. That's why diversification is crucial when it comes to financial planning, and why it may be a good idea to explore options beyond investing solely in residential real estate.
Fortunately, there is a way to tap into the value of your home while still living in it. With a home equity line of credit (HELOC) you can leverage the equity in your home to finance other investments or diversify your portfolio. This allows you to take advantage of the value of your home without having to sell it.
While your home is undoubtedly a valuable asset, it's important to diversify your investments for long-term financial stability. By exploring ways to tap into the equity in your home, you can take advantage of the value of your home while still living in it.
How to leverage your home to diversify your portfolio
When you borrow equity against your home, you are accessing the cheapest available form of financing that can be accessed by most individual investors. We’ve talked extensively about the benefits of incorporating leverage into your financial plan, but if you’re a homeowner, chances are you’ve already had plenty of experience with leverage through your mortgage.
Rebalancing periodically to a leverage level that fits your financial goals can help you diversify. By borrowing equity from your home, you can invest in other assets and avoid becoming too focussed in real estate equity.
The equity you’ve built in your home is illiquid and also doesn’t generate income. If you have the opportunity to borrow against this equity and invest into an income- generating asset that returns more than the cost of borrowing, it could help you reach your financial goals faster.
As a general rule, using leverage is beneficial when the expected returns from an investment exceed the cost of borrowing capital. For example, if you can borrow equity from your home at an interest rate of 4.00% annually to invest in a guaranteed 5.00% returning GIC, you’ll be profiting the difference of 1% with limited risk as GIC’s are guaranteed.
Keep in mind that high-volatility investments may carry significant risks, leaving you paying more interest than you can handle to hold on to your depreciated assets. When utilizing leverage it might be a better idea to consider less volatile, income-generating assets, such as bonds, dividend funds, and mortgage funds. These assets come with potentially less risk premium when compared to other assets like equities.
Perch Capital is an example of a mortgage fund which offers a 9% targeted annual return rate and could potentially represent a great opportunity for an investor to acquire an income-generating asset while still having exposure to the Canadian real estate market.
When you might not want to borrow against your home equity
Although a periodic rebalancing of your portfolio is advisable to all investors, taking on additional leverage might not align with everyone’s financial situation. First of all, accessing cheap financing is easier to do while you’re employed and may not be an option for you at all when you retire. After retirement you will no longer have qualifying income to take out a homeowners line of credit, so It’s important to plan ahead and make sure that you make these decisions as early as possible. The solutions that end up being available post-retirement are generally less desirable compared to options that exist while you still have income from a job. Options for tapping into home equity after retirement include reverse mortgages, private mortgages, renting rooms/parts of your house or selling your home to fund your retirement if you run short on cash, all of which might not be preferable to refinancing early and planning your portfolio in advance.