Which class do your purchases fall into? In order to find out we need to first look at what is the difference between an asset and a liability. The simple definition presented by Robert Kiyosaki in his excellent book “Rich Dad Poor Dad” is that an asset is something that puts money into your pocket while a liability is something that takes money out of your pocket.
With that basic definition out-of-the-way we need to look at how this actually works.
Let’s start with the easy ones Liabilities:
According to Robert Kiyosaki author of Rich Dad, Poor Dad, A Liability is something that takes money out of your pocket. The poor will buy things. They lack a long term perspective so they buy consumables and enjoy using them up quickly.
Typical “Assets” (Liabilities) of the Poor:
- A Car- It takes money out of your pocket in a variety of ways. The monthly payment, the interest on the payment, Gas, upkeep, insurance, and when you get ready to sell it you have a bundle of depreciation! It has gone down in value so you can’t even sell it for what you paid for it. That isn’t even taking into account the fact that the money you get for it is worth even less due to inflation.
- A “mobile home” or “Trailer”- Unfortunately, a trailer is more like a car than a house… it tends to depreciate and many of the same factors apply as to a car.
- A boat- same as for a car or a trailer, with additional expenses. A boat is often called a “hole in the water to throw money into”.
- Lottery Tickets- Who buys the most lottery tickets? The poor… they see them as their only way out of poverty but the odds are against them. They would be better going to Vegas, the odds of winning are better! Lottery tickets take money out of the pockets of the poor so they are liabilities.
- Furniture- The typical furniture bought by the poor only lasts a couple of years and then it falls apart, then it must be replaced. It continues to take money out of their pockets.
- The other main expenditure of the poor is “Consumables” this might be food, alcohol, cigarettes and drugs. Each of these rapidly removes money from their pockets without even the hint of putting anything into their pocket.
Middle Class Assets-
Liabilities Pretending to be Assets-
Next let’s examine the areas of grey that seem to affect most middle-class people.
Some things that might be Assets or Liabilities:
- Bank Deposits or CDs
- Real Estate
Let’s look at each one separately.
A bank deposit or CD is always an Asset right? Wrong!
If you deposit money into a bank and they pay you interest it is putting money into your pocket so you assume it is an asset. Right? But that is not necessarily the case.
A bank deposit or CD can actually be either an asset or a liability depending on the inflation rate and your tax bracket. You need to look at the big picture.
Bank Deposits or CDs:
Let’s look at this simple asset that almost everyone is familiar with, a CD or certificate of Deposit. We assume it is an asset for the depositor because it pays them an annual rate of return in interest. So if you buy a $1000 CD you give the Bank or other institution the $1000 and they promise to give you a certain rate of return for the period that they hold your money.
For simplicity let’s assume it is a one year CD so the bank will be holding your money for exactly one year. At the end of that time they will have to pay you a reasonable rate of return. What is a reasonable rate of return? Well, that depends on the current state of the market and the current inflation rate. Let’s assume it is 3%. So if you loaned the bank your $1000 they have to pay you $1030 at the end of the year. This sounds like an asset to you. This put $30 into your pocket. So it must be an asset right?
Let’s assume that you are in the 15% tax bracket and that inflation is 3%-
Lets look at the above CD once again. You deposited $1000 and received $1030 one year later.
On the $30 “profit” you have to pay 15% in taxes or $4.50 that reduces your net profit to $25.50
But in addition because of inflation your purchasing power on the $1000 actually declined by 3% making it worth only $970! Ah but at least you got the net profit of $25.50 right?
Not exactly, because you have to reduce that by inflation too! So in actuality your $25.50 profit is actually $24.735 let’s say $24.74.
So after a year of loaning out your $1000 you have $970 + $24.74 or a grand total of $994.74 or a net loss of $ 5.26! So what you thought was an asset is actually a liability! By loaning your money to a bank it actually took money out of your pocket!
If you buy stocks they are an Asset (they put money in your pocket):
- If they go up in price to more than offset the cost of inflation
- If they stay the same (in real inflation adjusted terms) but pay a dividend
If you buy stocks they are a Liability (they take money out of your pocket):
- If they go down in price
- Stay the same in nominal terms (but lose money in real inflation adjusted terms)
Brokers delight in telling us that, “Over the long run Stocks have appreciated an average of 10-12% per year” That sounds like even if we take away the cost of 3% average inflation and the effect of investing in stocks is to put money into our pocket.
Unfortunately, it doesn’t always work that way for the middle class either. What often happens is that the middle class only gets into the stocks at the top and ends up holding them until the bottom. So they have actually bailed out at the worst possible moment and have lost money. At any given moment there are sectors of the market that are set to rise (because they are undervalued) and sectors that are set to fall (because they are over-valued) typical middle class investors are buying the overvalued assets because they are the “hot” stocks and are selling the undervalued assets because either they can’t stand holding the loss anymore or because they aren’t the “in” investment.
So even though the “overall market” might make 10-12% per year individual middle class investors tend to do significantly worse. And once inflation and taxes are taken into account they may break even or actually lose money.
If you buy a bond it is an Asset:
- If it stays level and pays you interest
But a bond can be a Liability:
- If it goes down in price more than the interest it pays
The same analysis tends to apply for Bonds as stocks but the one advantage to a bond is that people tend to hold them longer and they are easier to analyze because the interest rate can be calculated, so bonds have a bit more chance to be an asset and put money into your pocket.
Have I confused you yet? I certainly hope not, but as you can see the process is getting more and more complex, so we need to look at the big picture as the wealthy do. When most middle class people think of Real Estate they think of their house. And because it is physical and can be sold they consider it an asset. At least it isn’t depreciating like a trailer!
Well is it putting money into your pocket? Well maybe not immediately, we all know we have to pay the taxes, insurance, and interest on the mortgage but we are hoping that when we sell it we will be ahead.
Let’s look at it a little more closely, you pay 6% interest to the bank and you get a deduction on your taxes for the interest you pay, so assuming you are in the 15% tax bracket again that means you save 15% of 6% or in effect your interest rate is reduced to 5.1%. Generally, over the long term your house will appreciate about equal to the inflation rate although at any given point the appreciation may be greater or less. By the time you get done paying for insurance, maintenance, upkeep etc. You actually about break even.
The reason home ownership is considered “American’s best investment” is primarily because the other ones are so bad! In actuality, since you have to live somewhere, you are eliminating the expenses of renting.
Generally, your mortgage is the last expense you will skip, (you don’t want to lose your house), so you are forced to pay into it every month.
The major advantages of home ownership is:
- It is a forced savings plan
- It is difficult to dip into (although it is getting easier with home equity loans, etc.)
So a home is actually a short term liability but may eventually turn out to be an asset.
Car, Boat, etc.
Just as in the case with the poor your car, boat, and furniture are simply liabilities since they take money out of your pocket. Although by buying quality, it may last longer and not depreciate as quickly.
So what do the Rich do differently?
Bank Deposits or CDs
The rich do not consider bank deposits or CDs “investments” they are simply holding places for liquid funds until they are needed to buy real investments or are needed to pay other expenses.
The rich also make sure that they are always earning interest on their money. I remember hearing a story of a wealthy bank client. He had a deal going through that wouldn’t close until about 4:30 on Friday afternoon. As we all know bank deposits made after 2:30 don’t get credited until the following business day. The signs in the bank say so right?
Well this particular gentleman couldn’t bear to have his money not earning interest over the weekend, so he made arrangements with his banker to keep the bank open (and credit him interest) starting on Friday afternoon! When a large deposit from a good client is at stake it’s amazing what can be done, isn’t it?
But the point of the story is that even though the money at stake was only 3/365ths of 3% (3 days interest at 3%) this wealthy person would not sacrifice that interest (on a Million Dollars it comes out to about $245). Why would a Multi-Millionaire be worried about $245? Because he learned the lesson young… Always, Always, Always have your money working for you!
When buying stocks the wealthy do not buy on emotion or “hot tips”. They do not buy for excitement or to be part of a crowd. They buy at the bottom of a cycle when no one else is interested. They buy when the average person would say they are crazy for buying and when what they are buying is entirely out of favor (i.e. they buy when it is cheap because no one wants it) so their risk of loss is low and their potential gains are high.
They manage their risks by ruthlessly cutting their small losses before they become big losses (but if they bought at the bottom the chances of this happening are small).
When buying bonds the rich buy for a specific purpose after carefully analyzing their risks. They may actually buy a bond for the income stream it produces. Let’s assume that a wealthy man wants to buy a new BMW. Does he just go out and buy one? Certainly not! He takes the money and buys a bond that will give him a 6% return. Then he goes out and borrows the money to buy his BMW at 3% or even 0% from the car company. Then he uses the interest from the bond to make his car payments. Once the car is paid off he has both his car and his initial principle (the bond). The rule here is Never dip into the principal only spend the interest!
When the wealthy think of Real Estate they don’t think of their own homes, they think of property that will put money into their pockets. Things like rental properties, houses, condos, strip malls, and self-storage units. Each of these pays excellent returns well above the cost of holding them. A reasonable rate of return may be 5-6% but wait a minute you say, I thought you said an “excellent rate of return”. At first glance you might think that 5-6% isn’t very good after all stocks should be able to earn that! Well that may be but when real estate is done right you put very little money up front and borrow the rest. Over time the tenants pay off the principal, you get wonderful tax deductions and in the end after it is all said and done, you may have earned 20% per year!
Are mortgages assets or liabilities? No I am not crazy as you might be thinking.
How can a mortgage be an asset? In this case I’m not talking about a mortgage on your house. Most middle class people only think about mortgages as part of owning their own house. They also think that owning a house is an asset. Which as I said before, in most cases it is not.
The first thing to realize is that almost all assets are also someone else’s liability. So when the wealthy think about mortgages they think about owning them i.e. loaning other people money so they can earn higher rates of interest. And as we said before, most people will make their mortgage payment even if they can’t pay for anything else.
Another way the wealthy think of mortgages is as part of a financing package to be able to buy more real estate. When combined with a good cash flow a mortgage can be an excellent way to get your tenants to buy a house for you.
Let’s go back to the bank for a moment with your $1000 deposit. Is it an asset or a liability? In strict accounting terminology it is an asset for you and a liability for the bank. But as we have seen earlier it is such a poor asset for you that it is actually a liability.
On the other hand even though it looks like a liability for the bank since they received $1000 and had to pay out $1030 so it appears to have taken money out of their pocket. (at the moment let’s ignore the effects of inflation).
Why would the bank do this? Obviously they are in business to make money so they are not giving you money out of the kindness of their hearts! They know that they can loan out your $1000 for more than 3% interest and keep the difference as their profit. So their entire deal looks like this:
- Borrow $1000 from you at 3% — Liability to them
- Create a Mortgage Loan for $1000 to someone else at 6% — Asset
- Net profit 3%
So the entire deal is not a liability for them. When looked at as a package the entire deal is actually an asset. They need to borrow the money so that they will have something to loan out at a profit. But that is getting a little more complex let’s move back to simpler things.
Hopefully, by now you are starting to see that a lot depends on circumstance and how you use the money. Borrowing is not always bad and money in the bank is not always good. You need to look at the entire package and determine whether it is putting money into your pocket or taking it out.
Let’s look at one final example, I mentioned this in my free report “15 Quick and Easy Ways to Beat 95% of All Investors”.
Let me tell you a true story about a guy named Bob
(not his real name)
Bob had a neighbor named Dr. Steve. Dr. Steve had a good practice and had been investing for a while and he was pretty good at it, too. One day as Bob was talking with his neighbor Steve, Steve offered to manage some of Bob’s investments. They were good friends and Steve had been successful so Bob agreed.
Bob and Steve each invested $10,000.00 of their own money. Naturally, Bob kept an eye on what Steve was doing with his money and after only a few years his $10,000.00 investment had grown to $100,000.00 (Steve was making him more than 20% per year!)
At that rate in a few more years Bob would be a Millionaire…
But because Bob didn’t understand what Steve was doing and how he did it he began to wonder…
Maybe Steve’s good luck would run out
Or the market would crash
Or the world would end
Or something and Bob would have nothing.
At this point…
What would you do if you were Bob?
Would you hang in there? And Risk the $100,000.00? (which really only cost you $10,000)
Or would you take the money and use it for a nice motor home?
Bob chose the motor home. With the swipe of a pen he turned a nice rapidly appreciating asset into a liability.
Now that you have read about the difference between assets and liabilities you should be able to tell why I said he turned an asset into a liability.
Let’s look at the stock portfolio that Dr. Steve was managing. Was it an asset or a liability? Was it putting money into Bob’s pocket or taking it out? Obviously it was putting it in because the portfolio grew 10 times.
Was the motor home an asset or a liability? Was it putting money into Bob’s pocket or taking it out? Well if Bob treated it like the wealthy and rented it out for a reasonable rate of return, it could have been an asset. Plus he would have had the added bonus of being able to use it a few weeks a year.
But unfortunately, in Bob’s case he treated it like a toy for his personal use and “since it was paid for” he didn’t feel he needed to rent it out. After all as Bob said, “what’s the point of having a motor home if you can’t use it any time you want?” So Bob’s motor home cost him up keep, taxes, etc.
If you would like to learn more about how the wealthy think and what they do differently in order to create wealth, read Rich Dad, Poor Dad by Robert Kiyosaki or any of his great other publications like Retire Young Retire Rich. They can truly change your outlook on life and open possibilities you never knew existed.