In grade eight accounting, we were told that an asset is something that you own, and a liability is something that you owe. But it did neglect one crucial factor: that an asset is also something that can generate cash flow. And merely owning something doesn’t necessarily mean that it’s making you any money.
For financial expert and author of The Wealth Chef, Ann Wilson, this is a vital consideration that many people overlook when they sum up their perceived wealth – particularly when it comes to the house that they live in.
“It’s absolutely key for me that when people develop their wealth plan they 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,” says Wilson.
And in this sense, your primary residence is actually a liability. Even if it is paid off, it does not generate any income for you and it costs you every month in rates and maintenance.
“For me one of the most insidious wealth destroyers is people not understanding this and believing that a bigger house is part of their wealth strategy,” Wilson says. “And unfortunately there is also an underlying societal belief that it’s a sign of success.”
The draw 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, because unless you sell that property and downgrade, you do not have something that can bring income into your life. While people might get a 20- or 25-year mortgage, the scary reality is that after 20 years of being home owners, most of them still owe huge amounts on their mortgages because of this pattern of constantly moving. . “In most of the western world, people move on average every seven years – upgrading to a new house. And every time they move, they get a new mortgage,” she says. “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.
She points out that many people are sinking money into these mortgages without building up a pool of real assets at the same time.
“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 rates. And, naively, they thought they were buying an asset.”
This doesn’t mean that Wilson discourages anyone from buying property. She just wants them to be aware of how that purchase fits into their wealth plan.
She points out that 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 she encourages people to buy and pay off their homes. 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.
Investment property is something entirely different. This is indeed an asset that can bring in income. However it’s not something that should be entered into lightly. You have to research what you are buying and what the investment return will be. Many owners of investment property don’t appreciate the importance of running this asset like a business.
“A lot of people become accidental property investors,” Wilson says. “For instance they start renting out the town house that they couldn’t sell when they got married. 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.
At SIRIUS, we encourage all our clients to have a well-diversified and balanced portfolio and to reduce all debt. We assist our clients in developing and maintaining a financial plan designed to preserve and grow their wealth.
Article adapted from Moneyweb