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Risk and reward of home equity borrowing for investment in Canada, a stochastic analysis

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  • Almas Naseem
  • R. Reesor

Abstract

According to Canadian tax law one way of transforming from non-tax deductible (personal mortgage) to tax deductible interest expenses is to borrow against home equity to make investments. A re-advanceable mortgage is a product in which the mortgagor immediately re-borrows principal as it is paid. We assume the re-borrowed funds are invested into a single risky asset and study the risk associated with this strategy to provide an accurate description of the mortgagor’s position. Our model accommodates stochastically changing interest rates and housing prices. We find that immediately borrowing from the increase in housing price decreases the expected mortgage payoff time, but also significantly increases the risk of taking a much longer time to pay off the mortgage. The risk of this strategy is very sensitive to changes in housing price volatility. Additionally, both the expected mortgage payoff time and the risk of taking a long time to pay off the mortgage increase with interest rate volatility. To reduce both the expected mortgage payoff time and the risk of a longer payoff time, the asset chosen should be (i) negatively correlated with housing price; and (ii) positively correlated with interest rates. From the case study using historical data we find that business cycle has an effect on the strategy’s performance and a reasonable decision rule would be to (i) implement this strategy at the beginning or in the middle of an expansionary period; and (ii) delay its implementation otherwise. Results of this study are relevant to homeowners, financial planners and policymakers. Copyright Springer-Verlag Berlin Heidelberg 2015

Suggested Citation

  • Almas Naseem & R. Reesor, 2015. "Risk and reward of home equity borrowing for investment in Canada, a stochastic analysis," Computational Management Science, Springer, vol. 12(1), pages 45-79, January.
    • Handle: RePEc:spr:comgts:v:12:y:2015:i:1:p:45-79
    DOI: 10.1007/s10287-014-0203-0
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    References listed on IDEAS

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