#173 Assets & Liabilities

Rich Dad Poor Dad

I first read Rich Dad Poor Dad by Robert Kiyosaki back when I was about 20 years old.  It was a great jumping off point to help me understand how money flowed and to learn the difference between an asset and a liability.  His way of thinking goes against the grain of conventional wisdom.  Even to the point of arguing that your home isn’t truly an asset because it takes money out of your pocket each and every month.

 

Assets & Liabilities w/ Jon Yolles

When I asked Jon how he explains assets and liabilities to a 12-year-old, here’s what he said.  “I think it's actually very simple.  An asset is anything that is yours, that is working for you.  A liability is somebody else's asset.”

 

Houses

Let’s use a house as an example.  If I own my home outright, that's my house.  I can sell it.  I can go to the bank and get a leverage mortgage.

On the other hand, if I own a house and I have a huge mortgage on it, I don’t really own that house.  I'm actually paying money to somebody else (the bank) to live in that house.  The bank loaned you the money to buy the house, therefore, it’s their asset and your liability.  It’s taking money out of your pocket every month in the form of a mortgage payment to the bank. 

Assets are things that you truly own.  Liabilities are what you owe.

 

Building Wealth

So, in order to build and create wealth, you have to have more assets than liabilities.  Let’s say you’re in the market to buy a home.  Now, most people can’t pay for a home outright in one swoop.  So, what do you do?  You go to a bank to borrow that money to purchase the house.  In this case the liability is necessary, but you want to make sure that you pay on the principle.

Nowadays people have way too many liabilities.  They’re racking up credit card debt on things they don’t need, not realizing the negative consequences.  Then, they get smacked with a massive credit card bill that they can’t pay off.  They’re stuck with a large balance; plus, the accruing interest the credit card company is charging them snowballs.

So, if you owed $10,000 and you couldn't pay it, and they're charging you 5% interest, now you owe 10,500.  It keeps growing and growing.  This is why liabilities can be so dangerous.  This is why it can be incredibly difficult to get out of credit card debt.

 

Buying a Property

Another scenario to think about is owning a rental property.  For example, let’s say you own a house or apartment unit that kicks back $200 in free cash flow.  “Free cash flow,” meaning you have $200 left over after you pay the monthly mortgage payment and other expenses.

Then, let’s say you have a liability that is costing you $200 per month.  Well, guess what?  Your asset just paid for your liability.  It’s a completely different way of operating.

 

The Flip Side

Using an asset to pay on liabilities in order to grow your personal wealth can be a fantastic strategy.  But what happens if your renters go away?  Now, you don’t have that free cash flow to pay for your liability.  So, now you have two liabilities that you have to worry about. 

It is important to know that there is still risk involved.  If the risk makes you feel uneasy, only buy things you can afford.

 

What’s the Worst-Case Scenario?

What’s the worst position you could potentially be in?  What happens if you lose your job?  Am I going to get evicted?  Is my car going to get repossessed?  Asking yourself these questions, and the revisiting them depending on what’s going on in the market is important.  Why?  Because it protects your downside.

Just look what happened in 2008 with the housing crisis.  You had tons of people that owned real estate and were renting out their units, right?  Then, boom gone.  The housing market crashed, and all the equity they had in it was gone.  People were stuck paying more for a mortgage than their house was worth.  You bought a house for $800,000, got a $600,000 loan on it, and now the house is worth $400,000.

This is why it’s important to understand exactly what you’re getting yourself into.

 

Paying Yourself First

Let’s say you make $4,000 after taxes.  Your goal should be to give somebody else the least amount of money possible.  Jon Yolles refers to this process as paying yourself first.  Pay yourself before you pay the bank.

You want to have more assets than liabilities.

So, if I get paid $4,000, I want to make sure I have assets and investments in the bank first.  Then, I’ll make my car payment.  Maybe that car payment is too expensive?  Maybe you don’t really need it. 

What’s the norm?  People paying the bank first.  They pay their car payment, grocery bill, and vacations before paying themselves.  All of a sudden, they’re running deficits every month.

In America we’re unfortunately in a culture of borrowing.  It’s no coincidence that companies send credit card offers to kids in college.  Kids sign up for their first credit card and what happens?  They rack up countless dollars of debt, they get out of college, and then they wondered what the heck happened. 

A good rule of thumb?  Strive to have more assets than liabilities.