Assets vs Liabilities

Is a home an asset or a liability

One believed, “Our home is our largest investment and our greatest asset.” The other believed, “My house is a liability, and if your house is your largest investment, you’re in trouble.”

A nice car and a nice house does not necessarily mean you’re rich or you know how to make money.

Assets vs Liabilities

Rule One. You must know the difference between an asset and a liability, and buy assets. If you want to be rich, this is all you need to know. It is Rule No. 1. It is the only rule. It is absurdly simple. This rule is profound. Most people struggle financially because they do not know the difference between an asset and a liability.

Rich people acquire assets. The poor only have expenses. The middle class buys liabilities they think are assets.

The simplicity of the idea escapes most adults because they have been educated differently. They have been educated by other educated professionals, such as bankers, accountants, real estate agents, financial planners, and so forth.

Why would someone buy an asset that was really a liability. The answer is found in basic education.

We focus on the word “literacy” and not “financial literacy.”

What defines an asset is not words but numbers. And if you cannot read the numbers, you cannot tell an asset from a hole in the ground.

In accounting, it’s not the numbers, but what the numbers are telling you. It’s just like words. It’s not the words, but the story the words are telling you.

If you want to be rich, you’ve got to read and understand numbers.

Here is how to tell the difference between an asset and a liability.

You need to look at the Income Statement, often called a Profit and Loss Statement. It measures income and expenses. Money in and money out. You need to look at the Balance Sheet. It is supposed to balance assets against liabilities. Many financial novices don’t know the relationship between the Income Statement and the Balance Sheet. That relationship is vital to understand.

Assets put money in your pocket. A liability is something that takes money out of my pocket.

If you want to be rich, simply spend your life buying assets. If you want to be poor or middle class, spend your life buying liabilities.

Illiteracy, both in words and numbers, is the foundation of financial struggle. If people are having difficulties financially, there is something that they cannot read, either in numbers or words. Something is misunderstood. The rich are rich because they are more literate in different areas than people who struggle financially. So if you want to be rich and maintain your wealth, it’s important to be financially literate, in words as well as numbers.

In financial reporting, reading numbers is looking for the plot, the story. The story of where the cash is flowing.

In 80 percent of most families, the financial story is a story of working hard in an effort to get ahead. Not because they don’t make money. But because they spend their lives buying liabilities instead of assets.

This is the cash flow pattern of a person in the middle class: Job (provides income)-> Expenses(Taxes Food Mortgage Clothes Fun Transportation) Asset (none) Liability (Mortgage Consumer loans Credit Cards)

This is the cash flow pattern of a wealthy person: Assets(stocks bonds notes real estate intellectual property)->income (dividends interest rental income royalties) Liabilities (none)

It is the cash flow that tells the story. It is the story of how a person handles their money, what they do after they get the money in their hand.

The flaw in the thinking of so many people is that money will solve all problems. More money will often not solve the problem; in fact, it may actually accelerate the problem. Money often makes obvious our tragic human flaws. Money often puts a spotlight on what we do not know. That is why, all too often, a person who comes into a sudden windfall of cash-let’s say an inheritance, a pay raise or lottery winnings-soon returns to the same financial mess, if not worse than the mess they were in before they received the money. Money only accentuates the cash flow pattern running in your head. If your pattern is to spend everything you get, most likely an increase in cash will just result in an increase in spending. Thus, the saying, “A fool and his money is one big party”.

We go to school to gain scholastic skills and professional skills. We learn to make money with our professional skills.

Today, doctors are facing financial challenges I would not wish on my worst enemy; insurance companies taking control of the business, managed health care, government intervention, and malpractice suits, to name a few. Today, kids want to be basketball stars, golfers like Tiger Woods, computer nerds, movie stare, rock stars, beauty queens, or traders on Wall Street. Simply because that is where the fame, money and prestige is. That is the reason it is so hard to motivate kids in school today. They know that professional success is no longer solely linked to academic success, as it once was.

Because students leave school without financial skills, millions of educated people pursue their profession successfully, but later find themselves struggling financially. They work harder, but don’t get ahead. What is missing from their education is not how to make money, but how to spend money-what to do after you make it. It’s called financial aptitude-what you do with the money once you make it, how to keep people from taking it from you, how long you keep it, and how hard that money works for you. Most people cannot tell why they struggle financially because they don’t understand cash flow. A person can be highly educated, professionally successful and financially illiterate. These people often work harder than they need to because they learned how to work hard, but not how to have their money work for them.

The story of how the quest for a Financial Dream turns into a financial nightmare. The moving-picture show of hard-working people has a set pattern.

Recently married, the happy, highly educated young couple move in together, in one of their cramped rented apartments. Immediately, they realize that they are saving money because two can live as cheaply as one. The problem is, the apartment is cramped. They decide to save money to buy their dream home so they can have kids. They now have two incomes, and they begin to focus on their careers. Their incomes begin to increase.

As their incomes go up…their expenses go up as well.

The No. 1 expense for most people is taxes. Many people think it’s income tax, but for most Americans their highest tax is Social Security. As an employee, it appears as if the Social Security tax combined with the Medicare tax rate is roughly 7.5 percent, but it’s really 15 percent since the employer must match the Social Security amount. In essence, it is money the employer cannot pay you. On top of that, you still have to pay income tax on the amount deducted from your wages for Social Security tax, income you never receive because it went directly to Social Security through withholding. Then, their liabilities go up.

This is best demonstrated by going back to the young couple. As a result of their incomes going up, they decide to go out and buy the house of their dreams. Once in their house, they have a new tax, called property tax. Then, they buy a new car, new furniture and new appliances to match [heir new house. Ail of a sudden, they wake up and their liabilities column is full of mortgage debt and credit-card debt.

They’re now trapped in the rat race. A child comes along. They work harder. The process repeats itself. More money and higher taxes, also called bracket creep, A credit card comes in the mail. They use it. It maxes out. A loan company calls and says their greatest “asset,” their home, has appreciated in value. The company offers a “bill consolidation” loan, because their credit is so good, and tells them the intelligent thing to do is clear off the high-interest consumer debt by paying off their credit card. And besides, interest on their home is a tax deduction. They go for it, and pay off those high-interest credit cards. They breathe a sigh of relief. Their credit cards are paid off.

They’ve now folded their consumer debt into their home mortgage. Their payments go down because they extend their debt over 30 years. It is the smart thing to do.

Their neighbor calls to invite them to go shopping-the Memorial Day sale is on. A chance to save some money. They say to themselves, “I won’t buy anything. I’ll just go look.” But just in case they find something, they tuck that clean credit card inside their wallet.

Their spending habits have caused them to seek more income.

They don’t even know that the trouble is really how they choose to spend the money they do have, and that is the real cause of their financial struggle. It is caused by financial illiteracy and not understanding the difference between an asset and a liability.

More money seldom solves someone’s money problems. Intelligence solves problems. There is a saying that people in debt need to remember: “If you find you have dug yourself into a hole… stop digging.”

As a child, my dad often told us that the Japanese were aware of three powers; “The power of the sword, the jewel and the mirror.” The sword symbolizes the power of weapons. America has spent trillions of dollars on weapons and, because of this, is the supreme military presence in the world. The jewel symbolizes the power of money. There is some degree of truth to the saying, “Remember the golden rule. He who has the gold makes the rules.” The mirror symbolizes the power of self-knowledge. This self-knowledge, according to Japanese legend, was the most treasured of the three.

The poor and middle class all too often allow the power of money to control them. By simply getting up and working harder, failing to ask themselves if what they do makes sense, they shoot themselves in the foot as they leave for work every morning. By not fully understanding nioney, the vast majority of people allow the awesome power of money to control them. The power of money is used against them.

If they used the power of the mirror, they would have asked themselves, “Does this make sense?” All too often, instead of trusting their inner wisdom, that genius inside of them, most people go along with the crowd. They do things because everybody else does it. They conform rather than question. Often, they mindlessly repeat what they have been told. Ideas such as “diversify” or “your home is an asset.” “Your home is your biggest investment.” “You get a tax break for going into greater debt.” “Get a safe job.” “Don’t make mistakes.” “Don’t take risks.”

It is said that the fear of public speaking is a fear greater than death for most people. According to psychiatrists, the fear of public speaking is caused by the fear of ostracism, the fear of standing out, the fear of criticism, the fear of ridicule, the fear of being an outcast. The fear of being different prevents most people from seeking new ways to solve their problems.

That is why my educated dad said the Japanese valued the power of the mirror the most, for it is only when we as humans look into the mirror do we find truth. And the main reason that most people say “Play it safe1’ is out of fear. That goes for anything, be it sports, relationships, career, money.

It is that same fear, the fear of ostracism that causes people to conform and not question commonly accepted opinions or popular trends. “Your home is an asset.” “Get a bill consolidation loan and get out of debt.” “Work harder.” “It’s a promotion.” “Someday I’ll be a vice president.” “Save money.” “When I get a raise, I’ll buy us a bigger house.” “Mutual funds are safe.” “Tickle Me Elmo dolls are out of stock, but I just happen to have one in back that another customer has not come by for yet.”

The following diagram illustrates the difference in perception between my rich dad and my poor dad when it came to their homes. One dad thought his house was an asset, and the other dad thought it was a liability.

Look at the direction of cash flow. Look at the ancillary expenses that went along with owning the home. A bigger home meant bigger expenses, and the cash flow kept going out through the expense column. For many people, a house is their dream as well as their largest investment. And owning your own home is better than nothing. But just look at an alternate way of looking at this popular dogma.

Most people do not agree with this argument because a nice home is an emotional thing. And when it comes to money, high emotions tend to lower financial intelligence. I know from personal experience that money has a way of making every decision emotional.

1. When it comes to houses, I point out that most people work all their lives paying for a home they never own. In other words, most people buy a new house every so many years, each time incurring a new 30-year loan to pay off the previous one.
2. Even though people receive a tax deduction for interest on mortgage payments, they pay for all their other expenses with after-tax dollars. Even after they pay off their mortgage.
3. Property taxes. My wife’s parents were shocked when the property taxes on their home went to $1,000 a month. This was after they had retired, so the increase put a strain on their retirement budget, and they felt forced to move.

4 Houses do not always go up in value. In 1997, I still have friends who owe a million dollars for a home that will today sell for only $700,000.

1. The greatest losses of all are those from missed opportunities. If all your money is tied up in your house, you may be forced to work harder because your money continues blowing out of the expense column, instead of adding to the asset column, the classic middle class cash flow pattern. If a young couple would put more money into their asset column early on, their later years would get easier, especially as they prepared to send their children to college. Their assets would have grown and would be available to help cover expenses. All too often, a house only serves as a vehicle for incurring a home-equity loan to pay for mounting expenses. In summary, the end result in making a decision to own a house that is too expensive in lieu of starting an investment portfolio early on impacts an individual in at least the following three ways:
2. Loss of time, during which other assets could have grown in value.
3. Loss of additional capital, which could have been invested instead of paying for high-maintenance expenses related directly to the home.
4. Loss of education. Too often, people count their house, savings and retirement plan as all they have in their asset column. Because they have no money to invest, they simply do not invest. This costs them investment experience. Most never become what the investment world calls a “sophisticated investor.” And the best investments are usually first sold to “sophisticated investors,” who then turn around and sell them to the people playing it safe. I am not saying don’t buy a house. I am saying, understand the difference between an asset and a liability. When I want a bigger house, I first buy assets that will generate the cash flow to pay for the house.

My educated dad’s personal financial statement best demonstrates the life of someone in the rat race. His expenses seem to always keep up with his income, never allowing him to invest in assets. As a result, his liabilities, such as his mortgage and credit card debts are larger than his assets. The following picture is worth a thousand words:

Educated Dad’s Financial Statement Income=Expense Asset < Liability

My rich dad’s personal financial statement, on the other hand, reflects the results of a life dedicated to investing and minimizing liabilities: Rich Dad’s Financial Statement Income > Expense Asset > Liability

A review of my rich dad’s financial statement is why the rich get richer. The asset column generates more than enough income to cover expenses, with the balance reinvested into the asset column. The asset column continues to grow and, therefore, the income it produces grows with it. The result being: The rich get richer!

Why the Rich Get Richer Income -> Assets -> More Income Expenses are low, Liabilities are low

The middle class finds itself in a constant state of financial struggle. Their primary- income is through wages, and as their wages increase, so do their taxes. Their expenses tend to increase in equal increments as their wages increase; hence the phrase “the rat race.” They treat their home as their primary asset, instead on investing in income-producing assets.

Why the Middle Class Struggle Income goes up, Expenses go up Assets do not increase, Liabilities do increase

This pattern of treating your home as an investment and the philosophy that a pay raise means you can buy a larger home or spend more is the foundation of today’s debt-ridden society. This process of increased spending throws families into greater debt and into more financial uncertainty, even though they may be advancing in their jobs and receiving pay raises on a regular basis. This is high risk living caused by weak financial education.

Suddenly, company pension plans are being replaced by 401k plans. Social Security is obviously in trouble and cannot be looked at as a source for retirement. The good thing today is that many of these people have recognized these issues and have begun buying mutual funds. This increase in investing is largely responsible for the huge rally we have seen in the stock market. Today, there are more and more mutual funds being created to answer the demand by the middle class.

Mutual funds are popular because they represent safety. Average mutual fund buyers are too busy working to pay taxes and mortgages, save for their children’s college and pay off credit cards. They do not have time to study to learn how to invest, so they rely on the expertise of the manager of a mutual fund. Also, because the mutual fund includes many different types of investments, they feel their money is safer because ii is “diversified.”

This group of educated middle class subscribes to the “diversify” dogma put out by mutual fund brokers and financial planners. Play it safe. Avoid risk.

The real tragedy is that the lack of early financial education is what creates the risk faced by average middle class people. The reason they have to play it safe is because their financial positions are tenuous at best. Their balance sheets are not balanced. They are loaded with liabilities, with no real assets that generate income. Typically, their only source of income is their paycheck. Their livelihood becomes entirely dependent on their employer.

So when genuine “deals of a lifetime” come along, those same people cannot take advantage of the opportunity. They must play it safe, simply because they are working so hard, are taxed to the max, and are loaded with debt.

The most important rule is to know the difference between an asset and a liability. Once you understand the difference, concentrate your efforts on only buying income-generating assets. That’s the best way to get started on a path to becoming rich. Keep doing that, and your asset column will grow. Focus on keeping liabilities and expenses down. This will make more money available to continue pouring into the asset column. Soon, the asset base will be so deep that you can afford to look at more speculative investments. Investments that may have returns of 100 percent to infinity. Investments that for $5,000 are soon turned into $1 million or more. Investments that the middle class calls “too risky.” The investment is not risky. It’s the lack of simple financial intelligence, beginning with financial literacy, that causes the individual to be “too risky”.

If you do what the masses do, you get the following picture. Income = Work for Owner Expense = Work for Government Asset = (none) Liability = Work for Bank

As an employee who is also a homeowner, your working efforts are generally as follows:

1. You work for someone else. Most people, working for a paycheck, are making the owner, or the shareholders richer. Your efforts and success will help provide for the owner’s success and retirement.
2. You work for the government. The government takes its share from your paycheck before you even see it. By working harder, you simply increase the amount of taxes taken by the government - most people work from January to May just for the government.
3. You work for the bank. After taxes, your next largest expense is usually your mortgage and credit card debt.

The problem with simply working harder is that each of these three levels takes a greater share of your increased efforts. You need to learn how to have your increased efforts benefit you and your family directly. Once you have decided to concentrate on minding your own business, how do you set your goals? For most people, they must keep their profession and rely on their wages to fund their acquisition of assets.

As their assets grow, how do they measure the extent of their success? When does someone realize that they are rich, that they have wealth? As well as having my own definitions for assets and liabilities, I also have my own definition for wealth. Actually I borrowed it from a man named Buckminster Fuller. Some call him a quack, and others call him a living genius. Years ago he got all the architects buzzing because he applied for a patent in 1961 for something called a geodesic dome. But in the application, Fuller also said something about wealth. It was pretty confusing at first, but after reading it for awhile, it began to make some sense: Wealth is a person’s ability to survive so many number of days forward… or if I stopped working today, how long could I survive?

Unlike net worth-the difference between your assets and liabilities, which is often filled with a person’s expensive junk and opinions of what things are worth-this definition creates the possibility for developing a truly accurate measurement. I could now measure and really know where I was in terms of my goal to become financially independent.

Although net worth often includes these non-cash-producing assets, like stuff you bought that now sits in your garage, wealth measures how much money your money is making and, therefore, your financial survivability.

Wealth is the measure of the cash flow from the asset column compared with the expense column.

Let’s say I have cash flow from my asset column of $1,000 a month. And I have monthly expenses of $2,000. What is my wealth? Let’s go back to Buckminster Fuller’s definition. Using his definition, how many days forward can I survive? And let’s assume a 30-day month. By that definition, I have enough cash flow for half a month. When I have achieved $2,000 a month cash flow from my assets, then I will be wealthy. So I am not yet rich, but I am wealthy. I now have income generated from assets each month that fully cover my monthly expenses. If I want to increase my expenses, I first must increase my cash flow from assets to maintain this level of wealth. Take notice that it is at this point that I no longer am dependent on my wages. I have focused on and been successful in building an asset column that has made me financially independent. If I quit my job today, I would be able to cover my monthly expenses with the cash flow from my assets.

My next goal would be to have the excess cash flow from my assets reinvested into the asset column. The more money that goes into my asset column, the more my asset column grows. The more my assets grow, the more my cash flow grows. And as long as I keep my expenses less than the cash flow from these assets, I will grow richer, with more and more income from sources other than my physical labor.

As this reinvestment process continues, I am well on my way to being rich. The actual definition of rich is in the eye of the beholder. You can never be too rich.

For adults, keep your expenses low, reduce your liabilities and diligently build a base of solid assets. For young people who have not yet left home, it is important for parents to teach them the difference between an asset and a liability. Get them to start building a solid asset column before they leave home, get married, buy a house, have kids and get stuck in a risky financial position, clinging to a job and buying everything on credit.

Buying luxuries

As your cash flow grows, you can buy some luxuries. An important distinction is that rich people buy luxuries last, while the poor and middle class tend to buy luxuries first. The poor and the middle class often buy luxury items such as big houses, diamonds, furs, jewelry or boats because they want to look rich. They look rich, but in reality they just get deeper in debt on credit. The old-money people, the long-term rich, built their asset column first. Then, the income generated from the asset column bought their luxuries. The poor and middle class buy luxuries with their own sweat, blood and children’s inheritance.

A true luxury is a reward for investing in and developing a real asset. For example, when my wife and I had extra money coming from our apartment houses, she went out and bought her Mercedes. It did not take any extra work or risk on her part because the apartment house bought the car. She did, however, have to wait for it for four years while the real estate investment portfolio grew and finally began throwing off enough extra cash flow to pay for the car. But the luxury, the Mercedes, was a true reward because she had proved she knew how to grow her asset column. That car now means a lot more to her than simply another pretty car. It means she used her financial intelligence to afford it.

What most people do is they impulsively go out and buy a new car, or some other luxury, on credit. They may feel bored and just want a new toy. Buying a luxury on credit often causes a person to sooner or later actually resent that luxury because the debt on the luxury becomes a financial burden.

After you’ve taken the time and invested in and built your own business, you are now ready to add the magic touch-the biggest secret of the rich. The secret that puts the rich way ahead of the pack. The reward at the end of the road for diligently taking the time to mind your own business.