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Sunday, December 21, 2014

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Cascade: No. 84, Winter 2014

Asset Diversification and Low Debt Are the Keys to Building and Maintaining Wealth*

In the mid-2000s, before the financial crisis, U.S. families set several records in their pursuit of the American dream of homeownership. These records include:

  • The highest rate of homeownership ever recorded — slightly more than 69 percent of all households;1
  • The highest concentration of assets in housing — 32 percent;2
  • The lowest annual personal saving rate since 1934 — 2.6 percent;3 and
  • The highest personal debt-to-income ratio — 135 percent.4

Asset diversification and reduced debt are recommended in light of the recession's impact on household finances.Asset diversification and reduced debt are recommended in light of the recession’s impact on household finances.

Greatly expanded access to home mortgages during the 1980s, 1990s, and 2000s appeared to make the American dream a reality for millions of families. Homeownership was attainable by many who, for the first time, were able to take out a mortgage with an extremely low or no down payment — even if they had a blemished credit history or none at all. For those with access to their accumulated home equity through mortgage refinancing or other home-secured borrowing, as well as to other sources of credit, lack of available cash no longer meant that they had to delay making routine purchases, buying a new car, starting a home renovation project, or pursuing the dream of college for a family member.

Unfortunately, rapidly accruing household debts, especially mortgage debt, over many years resulted in highly leveraged — and extremely fragile — balance sheets for many families.5 The result was that, when the financial crisis and ensuing Great Recession hit in 2007–08, millions of financially fragile families found themselves in dire financial straits. Mortgage foreclosures and consumer bankruptcies spiked, resulting in untold hardship for many families and a weak economic recovery.

How Did We Get Here? Family Balance Sheet Trends Before the Crisis

During the 25 years ending in 2007, Americans’ per capita disposable personal income more than tripled, while total assets owned per capita increased about five-fold. The value of assets owned increased faster than incomes primarily because stock and house prices increased rapidly. Meanwhile, the amount of debt of all kinds owed per person increased by a factor of six, while mortgage debt owed per capita grew eight-fold.6

The rapid increase in the amount of debt owed in excess of income or asset growth meant that many families were highly leveraged; that is, their debt was unusually high relative to their asset holdings, and their wealth was very sensitive to changes in the value of their assets. Therefore, these families were highly vulnerable to falling house prices.

Recovery of Wealth: Unfinished and Uneven

The Board of Governors of the Federal Reserve System recently reported that total household wealth once again exceeded the peak it had reached before the Great Recession and that household deleveraging — that is, steady declines in the balance of debt outstanding — apparently had come to an end.7 However, closer examination reveals that household balance sheet recovery is far from complete and is proceeding at an uneven pace depending on the individual family.8 The kind of assets a household owned going into the crisis and how much debt it owed significantly influence how well it is rebounding.

A family’s financial recovery is likely to be complete if the family happens to be among the one-quarter of American families headed by someone who (1) is 40 years of age or older, (2) has a college degree, and (3) is white or Asian. This is because demographic factors such as age, educational attainment, and race or ethnicity tend to be closely associated with certain balance sheet choices; therefore, groups of families defined by their demographic characteristics tend to experience similar wealth gains and losses.9 If, on the other hand, a family is among the three-quarters of U.S. families headed by someone who is under 40 years of age, does not have a college degree, or is black or Hispanic, financial recovery is likely to be far from complete.

An important reason why many younger, less educated, and historically disadvantaged minority families are struggling financially today is that many of them entered the recession with balance sheets that were not liquid or well diversified and were highly leveraged. That is, families who were already vulnerable to an economic downturn through job market risk had assumed more financial risk with their balance sheets, not less.10

Among all families, declines in the value of the average home accounted for 58 percent of the total loss of household wealth suffered during the financial crisis.11 But that number rises to 75 percent among families headed by someone who is under the age of 40; to 79 percent when the head of the household does not have a high school diploma; and to 88 percent for families headed by someone who is black or Hispanic.12

Two Keys to a Healthy Balance Sheet: Asset Diversification and Low Debt

How can a family that is headed by someone who is young, does not have a college degree, or is a minority break the historical link between economic vulnerability and financial fragility? The first crucial strategy is to diversify the family’s balance sheet while building wealth; the second is to maintain low debt. Neither is easy, but recent experience suggests these steps are necessary.

Asset diversification means owning several different kinds of assets, including safe and liquid bank accounts to handle emergencies; long-term saving vehicles such as mutual funds to accomplish long-term goals like education, homeownership, and retirement; and an appropriate amount of durable goods and real estate. Given the large upfront cost of buying a house, maintaining a diversified asset portfolio means homeownership generally will not be the first step on the road to financial stability; instead, it is more likely to be the final piece of the puzzle.13

Throughout the slow and steady process of building a diversified base of assets, a prudent family focused on financial stability will minimize or, if possible, eliminate its debt. In addition to being risky, borrowing generally is expensive for economically vulnerable families who might be required to pay relatively high interest rates and fees and who usually gain little if any tax benefit from deductible mortgage interest. Even middle-income families typically realize very little benefit from deducting mortgage interest. Virtually all low-income families are excluded from the tax benefit associated with paying mortgage interest.

The Bottom Line: Keep It Simple, Diversified, and Debt-Free If Possible

The bottom line for economically vulnerable families seeking financial stability is to maintain a diversified balance sheet with low or no debt. This means that homeownership may well be the final, crowning achievement signifying the attainment of financial success rather than an early strategy to pursue it. We have only to look at the tragic outcome of millions of foreclosed homes and shattered dreams to see the dangers of economically vulnerable families holding illiquid, undiversified, and overleveraged balance sheets.

Additional Resources

Several presentations given by the Center for Household Financial Stability’s staff members provide additional information about topics discussed in this article. “Financial Inclusion and Economic Recovery” lists studies on household wealth, shows a connection between youth savings and college graduation rates, and highlights the importance of short-term savings. “Why Did So Many Economically Vulnerable Families Enter the Crisis with Risky Balance Sheets?” and “Financial Sustainability and Strength (Assets)” also provide relevant information. To view these presentations, go to www.stlouisfed.org/household-financial-stability/presentations/. External Link