October 2016

Holistic Financial Wellness – More on Debt, Real Estate and Long Term Savings

Last month I talked about my father’s aversion to debt and how he integrated it into a coherent strategy for financial health. Today I want to look at another side of borrowing and talk about a friend whose abhorrence of debt and singular focus on that component of his balance sheet led him and his family into a situation where the lack of debt has created challenges that will be very difficult for him and his family to overcome.

Yaron is a very smart man. Son of Holocaust survivors he emigrated from Israel in his mid-30’s after a short but successful career as a logistics officer in the Israeli army. Shortly after coming to America he fell in love with Sarah, a Harvard educated emergency room physician who grew up poor but had recently been hired by a large Bay area Hospital system and whose future earnings prospects were very bright.

In short order they got married and had two equally bright sons both of which Yaron quite willingly agreed to take care of while Sarah focused on securing their financial future. In addition to his child rearing duties, Yaron also took on the task of making the strategic financial decisions in their lives. Now as I mentioned, Yaron was a logistics officer in his prior life and as such was very good at deciding on “critical paths” and taking “first things first”. To him, the first and most critical task facing their new family was to get rid of the almost $100,000 of student debt that Sarah had taken on in order to become a doctor.

Of course there were other looming financial issues in their lives as well. Specifically, there was housing and schools to consider, college tuition to save for and even further down the road retirement security to think about. Unfortunately, like many of us, Yaron prioritized these issues in terms of the timing of the expense (student loans first, then housing and schools, followed by college savings and finally retirement security). Not only that, but even more importantly, he failed to think about the connections between the issues and consider his financial situation holistically.

And so, he and Sarah spent almost all of their modest savings and the extra disposable income from Sarah’s practice on paying off the student debt that seemed to be a dreadful burden (both financially and psychologically) to them. After 5 years of disciplined budgeting they finally paid off the loan just as their oldest son was about to enter Kindergarten. In a perfect world, they would have purchased a home in a nice neighborhood, but despite being debt free, they did not have enough for a down payment and instead had to evaluate the trade offs between high rents in a good school district or paying for a private school education. Having done extensive research on school districts, test scores etc, Yaron and Sarah made the thoroughly rational (in isolation) decision to rent a small house in the section of town that had the very best public school system in the region and then being situated there, to save up for a down payment on a house in the same neighborhood (which of course had the highest house prices in the area).

Everything might have worked out, except the future is far more uncertain and unpredictable than we think. When they began paying off the loans it was the late 90’s and Yaron’s assumptions as to what would happen to both the residential real estate market and the price of a college education were way off. In the next 10 years the price of houses in Northern California (as well as the amount they would need for a down payment) skyrocketed at rates not seen before or since. Tragically, by 2007 when they had finally accumulated enough to purchase a house, prices had risen well past the point of rationality and Yaron (quite rightly) decided that this was a bubble that he didn’t want to participate in. Meanwhile, as this was going on, college tuition rates were increasing at double digit rates and as Yaron thought about that looming problem it seemed that paying for the kind of University his kids aspired to was something that would be even more difficult than owning their own home. Of course these two issues are intimately related and that was one of the key points that Yaron missed. Had he bought a house and taken on more debt instead of paying off Sarah’s student loans, the leverage associated with owning an asset worth 5 times as much as the amount of up-front cash required would have allowed their home equity to grow (over the long term) at a rate far greater than the increase in the cost of college (note that this is true even if year to year house price changes are volatile). Such a strategy would then have allowed them, over time, to both pay off the student loans and refinance their house to free up enough funds to pay for college. In short, had Yaron and Sarah thought holistically about their situation they would have been able to achieve all of their financial goals.

Some may ask why I haven’t talked about interest rates or taxes in telling Yaron and Sarah’s story. The short answer is that it wouldn’t change my message at all. In fact, had I done so, the availability of low fixed rate mortgages and the tax subsidies inherent in home ownership would have made the case for buying a house instead of paying off their student loans even more compelling.

In retrospect there was a small window of opportunity in 2010, after the Financial Crisis of 2008/09 when Yaron and Sarah could have caught the housing market on the way back up and perhaps purchased a house whose future appreciation would have given them sufficient home equity to tap into (via a Home Equity Line Of Credit )to finance their sons’ education, but as many of us remember, those were frightening times, both for the markets and for the economy as a whole and it was far from clear where house prices were headed.

And so now in 2016 with one son graduating High School in the spring and another just two years behind, Yaron and Sarah are facing an almost impossible financial situation that could have been avoided, not by “timing” the market via a 2010 house purchase, but rather by thinking holistically from the beginning, recognizing that assets and liabilities are both varied and connected, that not all debt is bad, and that almost all the financial decisions we make in the present have future consequences that while not predictable can be imagined and prepared for.