Monday, 30 January, 2006

Your House Is Not An Asset

It's surprising how many people view their cars or their houses as assets.  "It's worth $25,000," a friend said of his new car.  I didn't have the heart to tell him that although he paid $25,000 for the car last year, he'd be lucky to get $18,000 for it today.  If you view assets and liabilities in the traditional way, he's a few thousand dollars in the hole with an outstanding loan balance of about $21,000.

Houses are a little bit different in that a house often is worth more than you paid for it, and unless you got one of those negative amortization loans it's almost certainly worth more than the outstanding mortgage balance.  In the traditional sense, then, you're in the black:  disposing the asset will more than erase any associated liability.

The traditional way of looking at things defines an asset as something that you can convert to cash.  A liability is money that you're committed to paying at some point.  House, car, boat, home furnishings, etc. are assets.  Mortgage loans, student loans, credit card balances and such are liabilities.  If you add up the assets and subtract the liabilities, you obtain a number called "Net Worth"--the amount of money you'd get if you sold everything and paid off all of your debts.  Not surprisingly, a very large number of people--even "successful" people--in the United States have a negative net worth.

Net worth is a nice pretty number to figure out, but it's almost meaningless.  It's a fictional number that's usually based on over-valued assets and unreasonable assumptions.  And it's a worthless number because you can't spend your net worth.  In most cases, the best you can do is borrow against it.

A more realistic way of viewing things, popularized by Robert T. Kiyosaki's book Rich Dad Poor Dad, is cash flow.  Forget about what things are worth.  Figure out instead where the money goes.  How much money comes into your bank account every month and how much money goes out.  From a cash flow perspective, traditional assets and liabilities are meaningless.  In this alternate way of looking at things, an asset is something that puts money in your pocket and a liability is something that costs you money.

By this definition the only asset that most of us have is our daily job.  Your house, even if you have it paid off, is a liability.  Why?  Because it still costs you money every month for taxes and insurance.  Your car is a liability, requiring a loan payment, insurance, gas, registration, and maintenance.  Almost anything you buy is a liability, or at best neither--that is, it costs you nothing to maintain.

The trick to getting ahead is to increase your assets and reduce your liabilities.  Most of us increase our assets by putting our money in savings accounts, certificates of deposit, or mutual funds that invest in dividend paying stocks.  Rental property is another popular asset in which to invest, but remember that by our definition it's only an asset if the monthly income from rents, plus any tax advantages, is more than the monthly outlay for the property.  The equity you're building in the property with each payment doesn't count because it's not money going into your pocket.

I'll be the first to admit that this isn't the most sophisticated way to look at things, and that any second year accounting student could poke holes in some of the reasoning.  Many people will dismiss it as being too conservative and short-sighted because it doesn't take appreciation into account.  But that's okay.  I've seen all too many people with high net worth figures work their way through bankruptcy court because their cash flow situation became untenable.  I'd rather maintain a positive cash flow and treat any asset appreciation (in the traditional sense) as a bonus.

By the way, I wasn't terribly impressed by Kiyosaki's Rich Dad Poor Dad.  Powerful as it is, the cash flow method of looking at assets and liabilities is the only "new" idea in there, and it can be explained in a few short paragraphs.  The rest of the book is entertaining but not very enlightening.  That said, it's probably worth the price (under $20) as a gift to your children or to a friend who is struggling with finances.