Thursday, February 7, 2008

Assets or liabilities?

The key to financial freedom, and true wealth. What do you have? Do you even know the difference? Can something be both at the same time? Is your head starting to hurt from thinking that your about to get a lesson in accounting? Don't worry, it's not that bad.

Simply put, an asset is something that makes you money, while a liability is something that costs you money. That wasn't so bad, now was it?

The problem people have is they have more liabilities than they do assets...if they even have any assets. Sure, if you are a homeowner, you might think of your home as an asset, but rethink probably will appreciate over time, but so do the costs of owning that home. You have taxes, lawn care, repairs, routine upkeep, and on and on. There is quite a bit of expense associated with owning a home. This does not mean I am telling you not to buy a home, as I own one myself, and frankly, we have to pay to live somewhere. I would rather pay for my own place, and have a pretty good chance I'll build some equity, versus renting, where I build equity as well...but for the landlord. This is one of those things that can be both an asset (through appreciation over the years) and a liability (expenses of owning a home). Just remember, that equity is not liquid (unless you sell the home), or you take out a line of credit against it - but then it becomes another liability.

Liabilities will always be a part of our lives...the wealthy and financially free, know how to reduce their liabilities. We have taxes, we have utilities, we have necessities like food, clothing, education, transportation and such. Some of these liabilities we just can not do without. Liabilities like credit cards, satellite tv, and Starbucks we can do without.

Assets on the other hand, will put money in your pocket. They are a vehicle that puts your money to work for you. They can be anything from a profitable business you own, paper investments (stocks, bonds, mutual funds, etc), interest bearing savings, rental real estate properties (I don't consider one's primary residence to be an investment, per se, as it is not liquid, nor is it throwing off cash every month, like a rental would), etc.

True wealth comes, as well as financial freedom, when you have assets throwing off more money than you are spending with liabilities. Let's look at Mike and Joe. Mike works for a very large company as a regional sales rep. He makes over $500,000 a year in commissions. Mike and his family live a very extravagant lifestyle...they have a huge house, the newest luxury cars. They wear the finest clothing and travel to the most luxurious vacation destinations. They also spend more than they earn, and are financing almost all of it. Joe on the other hand, has $500,000 in investments, and is averaging an annual return of 10%, or about $50,000 a year. Joe is also debt free, except for his home, which is nearly paid off. Joe does not live extravagantly, but neither does he live like a pauper. He has two very nice used vehicles, dresses well (but not name brands), and saves to go on vacations. He also saves for things he wants to purchase, instead of financing them. Joe's total yearly liabilities are approximately $30,000 a year (between food and other living expenses, taxes and mortgage, etc). So who is wealthy? Mike, making over $500,000 a year, or Joe, making about $50,000 a year.

Joe is the wealthy one. Why? He does not have to work, because his assets are making more money than he is spending on his liabilities. Wealth is not a dollar amount, it is a state of being. If most of us would stop trying to keep up with the Jones' lifestyle, more of us would be able to surpass the Jones' lifestyle.

Saving money can be hard at first, especially for spenders like me. But it gets easier as you go along. It actually becomes fun. A close friend once told me, "If you do today what other's won't, you'll have tomorrow what others don't". There is wisdom in those words.


Danny said...

I disagree that the house is a liability, but it will become worth more in the future. A house is a great investment.

Steve said...

Danny, thanks for commenting. No argument, that a home is more likely than not going to appreciate over time, but it still costs you money to maintain and own. In one way, yes, it can be an investment, but to realize any gain in that investment, you need to sell it, to have that equity in hand...and then you need to find another place to live. Problem is, all the other homes have appreciated as well, and many people tend to buy up, going into a bigger home, so they go into debt again. The only way to realize that "investment", is to sell and downgrade your lifestyle, and use the profit to make you more money, say in a mutual fund. Like I said in my post, I'm not discouraging anyone from buying a house, but to look at it as a liability, and keep it in perspective. The whole "investment" angle is something I think realtors came up with to help make more sales. :D