By Cam McLellan
The number one reason that 99% of the Australian population are not wealthy, is because they don’t understand assets and liabilities.
Let me explain the difference between an asset and a liability.
In the investment world, an asset is something that makes you money and a liability is something that costs you money.
Look at the list below and decide which is an asset and which is a liability.
- A good, honest friend.
- An investment property with strong growth potential that puts money in your pocket each month.
- A mate who smokes, shoplifts or wastes your time.
- The family home.
- Serious liability. Don’t hang out with that fool!
- Technically an asset, though it comes with a non-beneficial liability (which I’ll explain soon).
We need to distinguish between appreciating and depreciating assets and beneficial and non-beneficial liabilities. You can allow for a liability if it serves a purpose, such as funding an appreciating asset. You need to think hard about non-beneficial liabilities, however, as they’ll seriously set you back.
You need to change the way you view everything in life. From this moment I want you to think of everything as either an appreciating or depreciating asset. Or a beneficial or non-beneficial liability.
The family home
People who consider the family home their greatest asset have no investment strategy. Due to its land content, it is an appreciating asset. But it doesn’t make money; it costs you. A home loan is a non-beneficial liability because it’s unrelated to wealth creation.
An investment property is also an appreciating asset due to its land content. A loan for this asset is a beneficial liability because it’s related to wealth creation.
Unless it’s a rare classic, a car is a depreciating asset, since its value reduces over time. Even if you pay cash for it.
Here’s my advice on buying cars while building your fortune.
Drive the cheapest car your ego can handle.
If your salary is $150k, don’t drive a $100k Mercedes; make do with a $20k Mazda.
Don’t get me wrong; I own several ‘toys’ and reckon I’ve earned the right to them. But I still enjoy driving my old ’89 Hilux. Plus it’s great for touch parking!
Flash cars do not make you a kingpin. With the money you save by being modest, you can hold another property or three.
Some of the worst advice an accountant can give is to buy a depreciating asset like a car to reduce taxable income. A smart accountant will advise you to buy an appreciating asset like an investment property with good land content.
The table below shows different asset and liability types.
You can apply the asset/liability test to almost anything. For instance, a mobile phone is a depreciating asset. Yet depending on whether your calls make money or not, a phone bill is a beneficial or non-beneficial liability.
Now that you understand beneficial and non-beneficial liabilities, I want to talk debt. Society has brainwashed us into thinking we must be debt free because all debt is bad.
This is where many would-be investors come unstuck. You must have confidence in the type of debt you acquire, and an exit strategy. This will reassure you that you’re on the right path. When you build a property portfolio, the figures get big pretty fast. If you don’t have a system to give you confidence, you may get anxious and lose your way.
My brothers and I sometimes stir our mum up about the debt we’ve accrued. Like all mums, she worries about her kids. We reckon it keeps her young if we wind her up now and then. It usually goes something like: ‘Hey, Mum; did you hear Bob picked up two more properties and is another million dollars in debt?’
Bob knows this is good debt because it’s a beneficial liability, but our mum is old school and thinks all debt is bad. Yet all her boys have a clear exit strategy and can handle large debt.
My point is, don’t be scared of good debt no matter how big it gets. So long as you can service it, and it’s part of your investment strategy, you’re on the right track.
It’s crucial you stay in control of your cash flow. Always keep a cash buffer. Should you lose your job, you need enough to cover loan repayments and other expenses until you get a new job.
‘How do I control cash flow?’ Download a budget template from the internet. The order in which you allocate money is key.
Your priorities should be:
- Debt repayment
- Utilities (e.g. power, water)
- Toys and holidays
Remember, cash is always king.
- Understand the two asset categories: appreciating and depreciating.
- Distinguish between beneficial and non-beneficial liabilities.
- While building your initial portfolio, drive the cheapest car your ego can handle.
- Don’t ever be scared of good debt.
- Stay in control of your cash flow. Keep a buffer. Cash is king.