What Percentage of My Net Worth Should I Have in My Home?

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Real estate investing comes with many benefits and is an effective tool for wealth building. Real estate can generate steady rental income to help achieve financial independence. Real estate equity grows over the long term and helps build wealth. There are additional benefits such as tax advantages and asset diversification.  

However, here are some questions that come up with real estate investing: 

• How much money should you invest in real estate? 
• What percentage of your net worth should consist of real estate and how much should come from other investments such as stocks, cash or alternative investments?

The answer is that it depends on a variety of factors. However, the rule-of-thumb is to maintain 20% to 40% of your net worth in real estate. 

But before we dive into this, let us look at how we calculate ‘real estate equity’ and ‘net worth’ in the first place.   

Read our article on How to Buy Your First Real Estate Property.

How to Calculate Real Estate Equity

Real Estate Equity = Current Market Value of the real estate property – Mortgage Balance

• Initial Stage - High Mortgage Balance, Low Equity: When you buy the property, right away there is a high mortgage balance. 
• Later stages - Lower Mortgage Balance, Higher Equity: But as the years go by, the mortgage value decreases as you are paying off the balance. Moreover it is likely that the property’s market value increases. Therefore, your real estate equity is likely to keep increasing as you hold the property for many years.

How to Calculate Net Worth

Net worth is calculated as follows:

Net worth = All assets – All liabilities

• Assets include cash, stocks, retirement accounts, and real estate.
• Liabilities include secured debt such as real estate and unsecured debt such as student loans, car loans, mortgage and any other personal loans.

Now that we’ve got the definitions out of the way, let us look into the rules-of-thumb and the factors that affect this ratio.

Rules-of-Thumb for Real Estate as a Percentage of Net Worth

In general the rule-of-thumb is that it is good to allocate 20% to 45% of your net worth in real estate. This allows you to derive the benefits of real estate investing while also ensuring you have enough asset diversification.

Would You Spend Half Your Net Worth on a House?Spending half your net worth on a single property is like parking all your resources in one massive garage. If the real estate market dips or your income changes, you may feel trapped.

Yet, in high cost-of-living areas, you may not have a choice but to devote a large portion of your wealth to housing.

Factors that Affect the Ratio of Real Estate to Net Worth

Age & Career Stage

• Early Career: When you are early in your career, you may not have saved much by way of stocks, cash or retirement accounts. But you may be buying your first condo or home. At this stage, a majority of your net worth is directed towards real estate. These 8 Financial Planning Tips for Young Adults can help you start diversifying your investments alongside real estate.
• Later Career: But as you progress through your career, you will save and invest more in stocks, retirement accounts or cash. 

Let us look at an example here.

Age 30: 

• Buy your first home for $500K with a 20% down payment of $100K and at a 5% mortgage rate, factoring in the differences between a nominal vs. real interest rate when planning long-term payments. Your home equity is $100K.
• You have $50,000 in brokerage accounts.
• Net worth = [Liquid assets +Home Value- Mortgage Balance] = $150,000
• Percentage of net worth in real estate = 67%

Age 35

• You have now accumulated $100,000 in retirement and $100,000 in brokerage accounts.
• Your remaining mortgage balance is $373.9K. 
• Your home value is $638,141 after appreciating for 5 years at 5%.
• Net worth = 464,241.
• Percentage of net worth in real estate = 57%

Now you have a more diversified mix of liquid assets, retirement assets and real estate.  

Age 40

• You have now accumulated $500,000 in retirement + brokerage accounts.
• Your remaining mortgage balance is $324.5K. 
• Your home value is $814K after appreciating for 10 years at 5%.
• Net worth = $989,871
• Percentage of net worth in real estate = 49%

Location

Location plays a huge factor in determining how much of your net worth is in real estate. 

• High cost of living areas (HCOL): such as the Bay Area, New York, LA may require you to have a higher proportion of their net worth in real estate. This is due to the high home values in these areas. For example, the median home price in the Bay Area is $1.2M and in LA it is $1 to $1.2M.
• Low Cost-of-Living Areas (LCOL): On the other hand, if you live in Low cost of living areas(LCOL), you do not need to buy expensive homes and your portion of net worth allocated to real estate tends to be lower.  For example, Cleveland, OH has median home prices of $130,000. 

Therefore, people living in HCOL locations will have a high real estate asset value as a percentage of their total net worth.

Existing savings and assets

If you have a lot of savings, stocks and other investment assets, the ratio of real estate to all your net worth becomes lower. This means that your portfolio is diversified, with your assets being allocated amongst multiple asset classes, including stocks, real estate, cash and others.

Risk appetite

If you have a higher ability and temperament to handle risk, you may be more comfortable with a higher ratio of real estate to net worth. However, people with a lesser comfort level with risk may choose to have a lower level of real estate to make sure that they have enough liquidity to cover any cash flow needs that arise from real estate downturns or other issues in other aspects of their finances.

Pros of having high real estate allocations

Wealth Building

A high real estate allocation helps you build wealth over a long horizon. You have high real estate equity with the potential for further appreciation.

Rental income

Real estate offers opportunities to generate rental income and cash flows. This can help one achieve financial independence and facilitate early retirement.

Cons of having high real estate allocations

Risk

Holding most of your net worth in real estate is a high risk move. Any drop in real estate values or an emergency like a job layoff may affect your ability to pay the mortgage. Moreover it leaves less ready cash available to cover living expenses in case of an emergency.

Opportunity Cost & Lack of Diversification

If much of your net worth is locked in real estate, you will have less cash or assets to invest in other investment opportunities. This prevents you from deriving the benefit of broad stock market growth, such as those highlighted in the Boglehead investment approach, ultimately reducing asset diversification.  

How to Think About Your Real Estate Allocations

Evaluate your reasons for acquiring real estate

What are your goals for acquiring real estate? Is it as a primary home, rental income or long-term wealth building through growth in real estate equity? 

Here is why the reason matters:

• If your goal is to buy a primary home, you may find that you are okay with spending more to buy your dream home and real estate may constitute a larger portion of your net worth.
• If your goal is rental income, you may choose to buy in locations where property values are reasonably priced, with rental income that exceeds mortgage payments. This may result in lower property values and real estate may take up a smaller share of your net worth. 

As you accumulate long term home equity through paying off the mortgage balance and appreciation of real estate assets, you could see a higher allocation towards real estate in comparison to other asset classes.

Make Sure You Have Asset Diversification & Liquid assets

It is important to have a diversified portfolio of stocks, cash, real estate and so on. Being overweight in one asset class makes your portfolio more risky in the event of a market downturn. For example, being overweight in real estate can be risky if real estate values were to go down suddenly, as was observed during the financial crisis of 2008.

Don’t Overextend Yourself or be Over-Leveraged

If you have taken on a lot of debt to buy property and the mortgage balance ends up being higher than the property value due to a fall in real estate prices, you could find yourself in a challenging situation. Because now you owe more than you can sell the property for, and may have to dip into other savings and assets to pay the mortgage. In addition, if your real estate ratio is too high, you may not have enough assets to cover mortgage payments.

Maintain liquidity

You should have a certain amount of money in liquid assets that can be easily tapped in the case of emergencies. You may also want to maintain liquid assets to take advantage of any new investment opportunities that come your way, and leaving too much in an illiquid asset class like real estate makes this harder.

Emergency funds to cover short term cash flow issues

You should have enough in emergency funds to cover any negative cash flows and mortgage payments, in case of market downturns, job layoffs and similar risks. Maintain enough liquid assets for unexpected expenses. Also look into overlooked workplace benefits that can save you money to boost your emergency reserves. 

Conclusion

The ratio of real estate to net worth depends on many factors such as age, location, existing assets and your risk appetite. While real estate is useful for building wealth and generating consistent rental income, a high ratio can also lead to high risk levels. Therefore it is important to invest in real estate while focusing on asset diversification and ensuring that you are not over-leveraged. 

At Planwell, we are building a fully automated AI financial planner and advisor to help you make super personalized financial decisions such as how much house you can afford, while considering your lifestyle, retirement goals and other key factors. 

We will be launching the product very soon. Stay tuned for an update. In the meantime, check out our blog posts to help you plan your finances.

• How Much House Can I Afford: Review our blog post on all the factors that determine your home affordability. 
• How to calculate rental income: A complete guide for new landlords.
• House Hacking: The complete guide to house hacking. 
• How to build a personal financial plan: Before you make a home purchase, make sure to build your personalized financial plan with our 10 step guide. 
• How to Use AI Budget Calculators and Tools to Plan Your Finances: Take advantage of modern technology to plan your finances more effectively.
• How much home can I afford: Calculate home affordability using standard debt-to-income ratios and your own personal financial situation and lifestyle.