24 January 2006

Hedging In Family Finances

Hedging is one of the most difficult and little discussed parts of personal financial planning.

What do I mean by hedging? I mean carrying assets and debt, and especially carrying long term financial assets and long term financial debts, at the same time.

Most people have a mortgage, and a mortgage is a type of hedging. You have both an asset, a house, and a liability, a mortgage, rather than, for example, renting a house and keeping the money that would have been home equity in some form of investment. There are lots of reasons people choose to do this, and they aren't all bad, despite the minority of people out there who abhore debt of any kind. A mortgage insulates you from rising rents (although less so if it is an adjustable rate mortgage). A mortgage receives far more favorable tax treatment than rent. And, home ownership with a mortgage allows you to benefit from rising housing prices on a leveraged basis (albeit, accompanied by the risk of a loss if housing prices fall). But, most people understand the pros and cons of this most common type of mixed asset hedging pretty well, without thinking of it in those terms.

The harder point is the balance between financial investments and long term debts. While the amount of analysis easily available on how to invest a portfolio of financial assets is vast and often not very expensive to obtain, and analysis of more narrow financial transactions, like whether or not you should refinance your mortgage, can often be reduced to financial calculators, the financial asset hedging issues is multifaceted.

Conventional wisdom among financial planners is that you should have an "emergency fund" in some fairly liquid and safe form (perhaps a savings account), equal to about six months of earnings, give or take. This is good advice. Shit happens. You could lose a job and need money to tide you over until you can find new employment. You could have a car accident or home theft or illness and have to pay deductibles on insurance policies. You can have car or home maintenance that needs to be attended to, or have to post bond after being arrested. The list is endless, but most of the usual little earthquakes in our lives can be avoided simply by being one or two paychecks ahead in life. Beyond that, the driving force behind the emergency fund is unemployment, although an emergency fund also ends up often overlapping with the cash supply that you keep in your checking account so that you don't bounce checks over the usual paycheck and bill payment cycle each month, and the cash you would like to set aside for short and medium term major purchases (like furniture, a new car, appliances and the like) so that you don't have to pay more future finance charges than you'd like in order to make that purchase.

Thus, even if you can afford to pay an extra 25% on your mortgage, which will save you a great deal of interest payments in the long term (as your mortgage company no doubt informs you with regular sales pitches for biweekly mortgage payments), you shouldn't until you have a full emergency fund, because if you come up short on your mortgage payment, you could go into default on your mortgage, which is costly, even if you can eventually set things right without losing your home.

On the other hand, other kinds of debt may be more tempting to pay off immediately, even if it means reducing emergency funds. My mortgage is at a fixed rate of 5.25% and I can take a tax deduction for the interest that I do pay, so I'm not in a rush to pay it off, and the tax deductible interest due on my student loans is at an even lower rate. Keeping money in an interest bearing savings account or certificate of deposit or bonds, while not paying low after tax interest rate loans, is a equivalent to paying a modest price in order to have a large line of low interest rate credit open to you. The equation is further muddied because some debts like student loans have both unusually benefits (e.g., certain kinds of discharged upon the borrower's death and are fairly easy to defer payments upon in times of hardship, but are very difficult to eliminate in bankruptcy).

But, the incentive to pay off credit card debt promptly, which involves a higher interest rate and doesn't involve tax deductible interest, is much greater. Beyond paying the minimum balance you have to make that decision you have to compare two very unlike parts of your financial life - the interest you will pay if you carry a balance versus the negative financial consequences of not being to pay bills at all for a month or two more if you are unemployed for a substantial length of time, an event whose probability is often hard to determine and whose magnitude is also often imponderable. The calculus is even more difficult when you are dealing with adjustable rate loans, where you must guess what the future cost of not paying that debt will be based on your necessarily imperfect predictions regarding future interest rates.

Tax considerations and investment returns drive other types of hedging. Retirement savings, educational savings and health care savings accounts typically come with tax benefits that often are equivalent to tax free income, and with penalties and other limitations on early withdrawals for improper purposes. Overfund them, and you might not have enough of an emergency fund (and in the case of a health care savings account, the idea is to replace some of your emergency fund). Underfund them and you miss out on tax benefits, and you may have a hard time sending your kids to college or retiring in comfort. Also, most retirement savings and educational savings are typically invested in some combination of stocks and bonds, which typically have higher returns than real estate appreciation (or the after tax interest cost savings of paying mortgage debt) and savings accounts, as well as being tax free income. But, stocks and bonds carry much higher risk in the short to medium term than paying off debt or putting money in a savings account, and educational savings can often come at the high cost of reduced eligibility for financial aid later. Retirement accounts and college savings are also forms of "dire emergency funds" available when you have tapped out your regular emergency funds and face the loss of a home or an inability to put food on the table or pay for a catastrophic medical bill due to sustained unemployment or some other unexpected situation.

Even without the tax benefits of tax favored accounts, you may feel that you can earn more money in the stock market (which is often taxed at a favorable 15% capital gains and qualified dividends tax rate) than you can by paying off debt (particularly student loan debt, business debt and mortgage debt, all of which is tax deductible), particularly coming out of the historically low interest rate environment we have just left (not that the stock market has been doing all that well by comparison). Also, these can serve as reserves for major purchases and serious emergencies that can be accessed without the downsides of withdrawing "dire emergency funds", while earning higher rates of returns during the bulk of the time when ordinary cash reserves are sufficient to cover the fluxations of daily financial life.

Finally, there is the issue of "personal considerations". For example, even if it makes economic sense to pool family financial assets to pay family debts, one spouse or another may, for example, like to keep inherited assets separate, rather than using them to pay off joint family debts like a mortgage, an incentive created by our divorce laws, which make it impossible for a spouse to prevent the other spouse from obtaining a divorce at any time. Similarly, even if paying off a higher interest debt might be more sensible in dollars and cents terms than investing the funds in even a tax favored college savings plan which invests in the stock market, many people are committed symbolically to saving for their children's future, and laws like the bankruptcy code encourage that attitude.

Even though it would be simpler for people to have only long term financial debts, or only long term financial investments, and even though sophisticated economists often deceptively talk about people saving or incurring debt, when most people do both, most rational actors in our complex tax and investment and risk environment almost always hedge to some extent. But, as this discussion illustrates, the variables are uncertain, the analysis is involved, the risks take patience and perspective to describe adequately, the literature on the subject in the personal financial planning area is sparce, and if you don't feel just a little uncomfortable about it, you are either an analytical wiz or haven't really taken enough time to digest the way that having a mix of financial investments and debts at the same time impacts your personal ability to grow your wealth and to manage your family's economic risks.

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