Many homeowners are close to that 40%-to-45% target. Nationwide, home equity represents just over 40% of median net worth.What if you have a large mortgage relative to your home's value?As a rule of thumb, if you start with the allocation I just outlined, for every $1 your mortgage rises above one-half of your home's value, you should increase your bond allocation by 75 cents and your stock allocation by 25 cents. So if you have a $500,000 home and increase your mortgage from $250,000 to $350,000, you should ideally allocate $75,000 of the proceeds to bonds and $25,000 to stocks.
The reason I recommend this is that as your mortgage rises, you are taking on more risk as a debtor. You offset that risk by buying more bonds, which makes you a creditor.What if your mortgage is below half your home's value?The relationship also holds in reverse, so for every $1 your mortgage falls below one-half of your home's value, you should decrease your allocation to bonds by 75 cents. If you have no mortgage and are aiming for an 8% return, an ideal allocation would be 10% bonds, 30% home equity, and 60% stocks.Are real estate investment trusts (REITs) a good substitute for home equity?REITs are backed by the real estate they hold. But they're also stocks, and money flows in and out of them a lot differently than it does with directly held real estate. As a result, REITs generally behave more like small-cap stocks than like real estate. So you don't get the same kind diversification benefit from REITs.
As your wealth increases, you should diversify your real estate holdings to include income-producing properties as well as your housing. Of course, if you have a pension, you may already have exposure to commercial property, since many pension funds put about 5% of their money into real estate.