The property conundrum đ
Back in high school accounting (urgggg), I was told that an asset is something that you own, and a liability is something that you owe. I accepted that as fact after all who was I to question the powers that be.
But that little âfactâ neglect one crucial factor – a vital distinction that makes all the difference. An asset is something you own that MUST earn money for you. Merely owning something doesn’t necessarily mean that it’s making you any money and expanding your wealth.
This critical distinction is one of the primary reason that so many people spend their lives filling up their wealth pantry with liabilities (things that cause money to flow out of their lives) believing they are filling their lives with assets and only discover too late that they are effectively broke.
It’s absolutely key that when you create your wealth plan that you understand that something that can bring income into your life is an asset, while something that causes money to flow out of your life is a liability. With this understanding you can start putting things in the correct drawer and know accurately whether the things you are spending your money on are taking you to wealth heaven or money hell.
The most common area where people get this wrong and where they incorrectly sum up their perceived wealth is the house they live in.
Your primary residence, the home you live in, is a liability. Even if it is paid off, if it does not generate any income for you and it costs you every month in council taxes, utilities, insurances and maintenance – it is absolutely not an asset.
One of the most insidious wealth destroyers is people not understanding this and believing that a bigger house is part of their wealth strategy. Unfortunately there is also an underlying societal belief that it’s a sign of success.â
The allure of a bigger, better house
Many people are seduced by the idea that progressing to a more expensive house means they are securing a bigger asset. However, they are actually digging themselves into a bigger financial problem.
The poverty cycle looks something like this.
You keep moving up, from a one bedroom flat to a terrace, to a free-standing bungalow, to a better suburb. Due to complete naivety, your money is flowing into something which you believe is an asset. But actually you are now trapped, because unless you sell that property and downgrade, you have nothing that can bring income into your life and so you have to keep earning.
This is the trap of the aspiring middle class.
While people might get a 20 or 25 year mortgage, the scary reality is that after 20 years of being home owners, most still owe huge amounts on their mortgages because of this pattern of constantly âupgradingâ. In most of the western world, people move on average every seven years â upgrading to a new house. Every time they move, they get a new mortgage and they don’t realise that even though they think that because they have a bigger property, they have a better asset, all they are really doing is expanding their liability drawer.
This is because if you’re moving every seven years, you have barely reduced the capital on the mortgage debt. Mostly, you’ve just been paying off interest.
With the introduction of interest only mortgages on principle residences this has become ever scarier. Thousands of people opted for interest only mortgages but failed to make adequate provisions to ensure they could pay these off with real assets that earn money for them.
This is what happens when people don’t understand the fundamental difference between an asset and a liability. Certain people will end up at the end of the 15 year interest-only period being forced to sell the property, possibly in a down market. They will be left with no home, no assets and all they have done is paid exceptionally expensive rent for 15 years, while also being responsible for all costs on the house like maintenance and taxes. And, naively, they thought they were buying an asset.
Donât get me wrong – I love owning my own home. Just donât be misled into believing your home is a wealth creating asset.
Having the security of a roof over your head that nobody can take away is also a vital part of your financial well-being. And I encourage people to buy and pay off their homes.
But don’t believe that it is something that goes into your asset pot as part of your wealth strategy. Don’t keep upgrading to a bigger and bigger house if you’re not at the same time putting money towards proper assets that can bring income into your life and feed you when you no longer feel like working for money. If you believe your home is an asset you could end up with is a nice fancy home, but starving.
Investment property is something entirely different. This is indeed an asset that can bring in income.
Property is such a great investment because it’s the easiest asset class in which to use leverage. In other words you use debt in a way that expands your wealth, rather than destroying it.
Leveraging and using debt to accelerate your wealth is not something that should be entered into lightly. You have to research what you are buying and what the investment return will be.
The key with investment property is to understand that everything is in the numbers. Put aside all your beliefs and emotions and just look at whether it makes financial sense.
Many owners of investment property don’t understand the importance of running this asset like a business and this is because many become âproperty investorsâ by accident. For instance they start renting out the apartment they couldn’t sell when they got married or they inherited great aunty Mabel’s house when she died but they never really understood the numbers. You have to realise that just owning a property doesn’t make you a good property investor.
And the most important part of being a good property investor is understanding the risk and reward balance of taking on debt.
Leverage (using good debt to accelerate your wealth) is like fire. It can absolutely destroy and burn you, but at the same time it can warm and protect you. Investment property is the easiest and most powerful way to use it to do that.
Iâd love to hear your thoughts on this article, did this surprise you to discover your home is not an asset? Please share in the comment below.
Speaking of property investing, I convinced Scott Picken, CEO of Wealth Migrate, a leader in new technology enabled property investing to do aÂ complimentary Property Investing MasterclassÂ for all us Wealth Chefâs