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Are all assets good and all liabilities bad?

Last time, we discussed how to get ahead of the game. This will leave you with surplus to invest. Investing means buying assets. Which assets? Should you use debt? Can you reach financial independence?

Let’s take a look at assets and liabilities and figure what’s good and what’s not.

Assets – the key to financial independence

From an accounting perspective, an asset is a resource owned by an individual or a business which has future economic value that can be measured. What does this mean? You own something of value and would provide money if you sold it.

Keeping it to a personal perspective, an asset would include your house, car, artwork and investments.

A main goal for most Australians is to own their own home. “Your greatest asset”. In 2019, 67% of households were homeowners (with or without a mortgage) (aihw.gov.au).

What is a mortgage? A mortgage is a type of loan (usually from a bank) to finance property.

When you buy a home, as most people can’t pay 100% cash for it, you need to borrow money to add to your deposit.

Deposit: A deposit is your initial contribution to the purchase price of a property. You provide, for example, the initial 20% and the bank will lend you 80% of the property value.

Other types of assets:

• Shares (also known as stocks).
• Property – residential, commercial, industrial.
• A business.
• Art.
• Cryptocurrency.
• Non-fungible tokens.

This is not an exhaustive list, nor are they recommendations.

Assets are a good thing, right?

Now I want you to compare the accounting definition of an asset to one provided by Robert Kiyosaki of Rich Dad Poor Dad fame.

His definition of an asset:

It is something that puts money into your pocket on a regular basis, with the least amount of direct work.

It is so crucial to understand this definition of an asset.

Is your house (your primary residence) now an asset? No.

Your car? No

Expensive artwork? No.

Why not?

Because they don’t put money into your pocket on a regular basis. It costs you to hold them.

I understand that property prices, over the long-term, go up in many instances. However, owning your own home is a major cashflow drain. It costs a lot to maintain a house. These expenses come out of your after-tax income.

When do you get to benefit from the value from your home?

If you are like most people, the aim initially is to get a foot into the property market, live there for a few years and pay down some debt. Then move to a bigger property, with a bigger loan and pay down some debt. Then move to a nicer area, with a bigger loan and so on.

Your car. Petrol, servicing, immediate decrease in value once you drive out of the car yard. Another constant drain on your finances. In most cases, you will sell it at a significantly reduced price.

Even artwork. You have to insure and protect it. Then you hope it goes up in value.

Robert Kiyosaki calls these liabilities.

Do these types of assets have the capacity to make you wealthy?

Generally not. Yet so many Australians will go deeper into debt for the nicer house, better suburb or flashier car.

You risk becoming the pink dot (from the last post). You can easily become cashflow negative.

Debt or very strong cashflow is required to keep afloat.

Liabilities – these sound bad

A liability is generally defined as something a person owes. Usually money. Also known as debt.

Your loan to the bank is a liability. You must pay the bank back what you have borrowed plus interest. A home loan, for example, can last for 30 years.

What is interest? Interest is the cost of borrowing money. If a person lives in your investment property, they pay you rent. If a person borrows money from you, they pay you interest.

For example, if you borrow money to buy a home, your repayments will comprise a repayment of the principal (what you originally borrowed) and an interest charge.

I found this excel mortgage repayment schedule on the internet.

(only the first three repayments have been shown)

The loan amount is $600,000 (the principal).

The loan term is 360 months (30 years) which is a typical home loan duration.

Interest rate is 3.50% and assumed to stay the same. In reality, this will not be the case. It can go up or down.

Monthly repayments are $2,694.27.

Each monthly payment comprises a payment of principal ($944.27) and interest ($1,750.00).

Generally, interest payments are higher in the beginning and lower towards the end of the loan. The more you pay down the principal, the lower the interest payments.

The 360^th repayment (not shown) is $2,678.60 of principal and $7.84 of interest.

If you look closely, you’ll see the total interest paid. $369,936.53 over 30 years.

Say you purchase a home for $750,000.

Your deposit is $150,000 (20%).

You borrowed $600,000 (80%).

Total cost of your home over 30 years

 = $750,000 + $369,936.53 = $1,119,936.53 plus maintenance costs

Hopefully, you purchased in a reasonable area with capital growth potential.

Capital growth: an increase in asset value over time.

If your home increased in value by 4% per year, after 30 years it would be worth $2,338,989. That’s great. But you can’t get access to the cash unless you sell and buy a cheaper property.

Robert Kiyosaki defines a liability as something that takes money out of your pocket.

When you factor in interest payments and other costs of maintaining a house, by this definition, your home is a liability.

Your home is constantly taking money out of your pocket.

Having said all of this, as the value of your home increases over time, you are building the equity in your home. With the price rise, the amount of the home you own, increases. Initially, the equity (the part of the house you own and not the bank) is the deposit. Over time, you slowly own a greater percentage of the home. This equity is useful as you may be able to use it by borrowing more from the bank to buy a bigger home or to invest.

Robert Kiyosaki doesn’t consider this. That is because CASHFLOW IS KING.

I hope you are starting to understand how you invest your money can have significant ramifications on your wealth position.

Should you purchase your own home? That’s a decision entirely up to you as it depends on what is important to you.

Critical note: In Australia, when you sell your primary residence (your home), if you have never rented it out in the time you have owned the property, the capital gain you make is 100% tax-free. This is different to the USA.

Financial planners generally recommend that you have a debt-free home by retirement.

The good, the bad and the necessary of debt

There are various flavours of debt.

Debt has the capacity to create tremendous wealth. But the wrong type of debt can destroy wealth, along with your future.

Necessary debt

Your home loan is seen as a necessary debt. In Australia, it is deemed important to own your own home. Do you really want rent to be eating away your savings in retirement?

As long as your home is appreciating in value, this is tolerable debt.

If you purchased poorly and your home is not appreciating, or even worse, depreciating (yes this can happen), then it could be classified as bad debt.

Your student debt resides in this category too. Your student loan interest is very low. Not too much damage done here.

Bad debt

The worst of the worst – pay-day loans. Short term loan companies that charge massively high interest rates. As high as 50%!

If you are implementing what you are learning from FIT Wealth, you will never have to go there.

Next in line are credit cards and Buy Now Pay Later. If you pay off your debt in full when due, that’s ok, but research shows that people spend an extra 12%-18% when using credit. This suggests poor spending habits. Close attention to your expenditure is important.

If you can’t afford to pay for it upfront, maybe you shouldn’t be buying it. Arguably, this includes a car because interest on loans for cars are often in the range of 6-10%. I’ll leave you to agree or disagree with that comment!

Good debt

How can there be good debt?

Most larger businesses have debt, a lot of wealthy people have debt.

Why?

They use debt to make money.

Key point: The interest on debt used to purchase an income-producing asset is tax-deductible.

Income-producing asset: An asset that puts money into your pocket.

Tax-deductible expense: This is an expense that reduces your income in the eyes of the Australian Tax Office.

If you buy an investment property (in your own name) the cost of the interest can reduce your taxable income.

Keeping it simple. Say rent received is $30,000 this year and the interest paid to the bank is $10,000. You would be taxed on $20,000. Not the full $30,000.

This is not the case with your home (primary residence).

Any interest you pay on your home loan or other loan for a non-income producing asset does not reduce your taxable income.

An education course that is relevant to your career can be tax-deductible as it is hoped that the course will increase your value and result in an increase in your income. In this case, you are the income-producing asset.

When purchasing an asset, the aim is to either grow the value of the asset over time and/or produce an income.

Two common assets purchased with debt are property and shares. You could also buy a business.

Clearly, when buying an investment property, you will most likely need to take on debt. An investment property aims to achieve both income and capital growth. You get income from the rent and if you’ve purchased the right property in the right area or have enhanced the value via a renovation or development you will benefit from capital growth (with property, knowing the expenses involved is critically important).

A riskier strategy is to use debt to buy shares.

Say you have $30,000 in a ASX listed company. The bank may lend you up to $70,000 to buy more shares. Total $100,000.

You receive income (dividends) on the whole $100,000 and if the shares go up in value, you get all of the gains. Remember, you will also have to pay interest on the amount borrowed. The aim is for the combination of dividends and capital growth to be higher than the interest expense. This is unlikely to happen every year.

Dividend: a payment by a company to its shareholders out of its profits. Not all companies pay dividends.

On the flip side, if the company does not pay a dividend or the share price goes down, you still have to pay the interest. If you have taken a loan through a margin lending facility (beyond the scope of this post) and the value of the shares decline substantially you may have to pay money to the bank from your personal funds.

With debt comes increased risk.

Calculated and well-managed risk can lead to success.

Liabilities to buy assets to generate income and/or capital growth = Financial Independence

The typical flow of money.

The income from your job goes to the bank which reduces your loan amount. What you have left over, you can spend or save and invest.

The better flow of money. A passive flow of income. When you first start working, your aim is to save and invest.

At this point, you are still working. You are saving and investing in income-producing assets (shares or property). The income from these assets is going to your bank account. Hopefully, you are getting growth in the value of your assets as well as income.

With time and good asset selection:

Yes, the bigger bank (as in bank account) is deliberate. Over time, you have invested sufficiently to match your income from you job.

You get to choose if you want to work or not.

And finally, if you’ve done everything really well – financial independence:

Important Concepts

Gearing: The relative proportions of debt and equity (the portion you actually own) in the asset that you control. For example, you own $30,000 of shares in company XYZ and you borrowed $70,000 to by more shares in XYZ, your gearing level is 70%.

(Total debt ÷ total value) x 100

Positive gearing: This is when the income from your investment exceeds all the expenses. Say rental income is $30,000 and your expenses (including repayments) are $25,000. You have $5,000 in your pocket at the end of each year.

Negative gearing: This is when your expenses exceed your income. Say rental income is $20,000 and your expenses (including repayments) are $25,000. You are $5,000 down at the end of each year. However, you can generally claim a tax deduction for the loss on the investment (not if the investment is in a trust or company). In this scenario, the aim is for capital growth to offset the loss.

The Wrap

Important take home points:

1. You need to work to generate the initial income (job or a business). Always be increasing your value.
2. Start as early as possible. Save and invest. Allow compound interest to work its magic.
3. Buy the right assets.
4. Use debt wisely to make you money.
5. Understand and mange risk well.
6. Have the right team of professionals around you. It is infinitely more difficult trying to do it all yourself.

I can’t tell you what is important to you. This may not be for you. All I want to do is to open your eyes to the possibilities. That allows you take greater control of your journey through life.

Up next …..

Investing – The wonders of compound interest

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