An Engineering Approach to Money

I know you’re going to be shocked, but just like the fact than All Assets are Not Equal, the same holds true for liabilities. A liability is something that you owe. Most liabilities are loans of one form or another. I’m sure you’ve all heard how bad credit card debt is, this is a clear example of a bad liability. Any time you are borrowing money to purchase anything other than an good asset you are incurring a bad liability, I’ve talked about this before. The worst of the worst is to use debt to purchase a service. While reading blogs the other day I stumbled across a guy who was going to finance his Honeymoon with credit card debt. This is a huge mistake, and is incurring the worst kind of debt. If you are putting “fun” stuff on your credit card because you have not saved the cash for them, then you are simply living beyond your means. In this case Matt simply can’t afford this Honeymoon and would be much better spending less, perhaps much less. How about a nice camping trip at a National Park Matt?

Good liabilities are those where you are borrowing money to purchase an asset that will return you more than the liability will cost. An example of this was that I took about $20,000 out of my home equity when I refinanced by house back in 2001 and put that money into the stock market. In my case it was in the Mathews Pacific Tiger Fund. I purchased 2,809.2 shares @7.15 on Oct 16th, 2001. I ended up paying about 4.75-6% for that money (I refinanced again in 2003), but those shares are worth $25.12 today (4/20/07). To borrow that money for 5 1/2 years cost me approximately $6,000, but returned about $50,000. I could sell my shares to cover the original $26,000 loan + interest and still have $44,000 left over. In this case I got very lucky and hit a jackpot investment. But even if it grew much less I have an asset in my hands to pay off the loan with. Compare this to Matt who will have to use future earnings to pay off the credit card debt he is going to take on.

Some rules of thumb

• Never take on debt to purchase something “fun”. If you will have fun spending the money don’t do it with borrowed funds. Save first, then have fun spending the money.
• Never borrow money to buy anything that is not a good asset.
• Borrowing money, even for good assets increases your risk. What would you do if the value of the asset you purchased with your borrowed money lost half its value? Beginning investors should try to never borrow money.

But Kit, what about borrowing money to buy a House or a Car, is that bad? As with most things, it depends. I’m not a fan of car loans at all. The only time you should be borrowing money to purchase a car is if you absolutely need that car for basic transportation. In this case borrowing the money will allow you to increase your income, because you can now get to work, over what it would be without the car. But there is no real excuse for buying anything more that basic transportation this way. If you are spending more that $10,000 or so on your car, you should not be borrowing the money, just buy a cheaper car.

The argument that you need a car to hold down a job, and thus borrowing the money to buy the car is a good financial move can hold water. But only if you are buying the most inexpensive car that will meet that basic need. If you are borrowing money for a BMW then you are incurring bad debt. If you want an expensive car then you need to save the money first and then buy that trophy car. Hey it’s your money, spend it any way you want. But don’t try to convince me that you job requires you to have a certain image and thus a certain car. I’m not buying any of that.

Home Loans are even more complicated. Because your home is both an investment, and consumption. In addition, it’s not realistic to save $200,000 or more for a home before you make the purchase. So a decision to borrow money to purchase a home can be a good thing. But you should be very careful about the kind of loan that you take. Any time you take any loan you are increasing risk. Even if the asset drops in value you still have to make payments on the loan, and if you sell the asset you must pay off the full value of that loan, even if the value of the asset does not cover that loan.

Consider a house purchased with only 3% down. You are immediately in the hole because to sell a house you have fees to Realtors and other costs that can run between 5 and 8% of the value of the house. You may also have to drop the price below market value if you are in a hurry to sell. All this means that unless you are putting at least 10% down on a house you are counting on the value of the house to go up to get you out of the situation. For the past 4 years prices have been rising so fast that it has covered everyone taking this risk. But there is no guarantee this will continue. In fact, prices have risen so far so fast it is likely that prices may stay flat or even slowly decrease over the next few years.

I believe this is the reason why traditionally a 20% down payment was required to purchase a house. With 20% down the odds of your ending up in a bad situation is significantly reduced. Therefore, I believe that unless you can afford to put down 20% to purchase a home you can’t afford it. Either save more money, or buy a cheaper house. According to this about 80% of the people are purchasing more house they cannot afford. From what I’ve seen that’s probably not that far wrong.

The biggest mistake that most people make is spending more money than they have. Easy credit and taking out bad loans is what allows people to make this mistake. It also can hide the effects for years. But eventually it will catch up with you. By paying with cash or doing without you will already be in an elite class of people who take responsibility for their own actions, are willing to live within their means, and are on the road to financial success.

Full Disclosure: I don’t have any car loans, but I do have a Mortgage on my house. I put 20% down, and the loan to value ratio on the property is now about 50%.

Earlier we talked about totaling up your assets and your liablities on a regular basis to know your net worth. At the time I kind of skipped over exactly what is an Asset and what is a Liability.

What is An Asset

So let’s start with assets. An asset is anything that you can turn into cash. It does not need to be cash, it can simply be something you can sell for cash. It should be valued at its fair market value. But please don’t be overly aggressive, some things can fetch a big premium if you take the time to find exactly the right buyer and get full value. This is not a realistic valuation though. What I try to do is value all my assets at whatever I could get if I needed cash in a hurry. A stock can be sold in a hurry for the market value and the cash will be there in 2 or 3 days. A car is trickier. If you needed to sell it in a hurry you might have to sell it for 10 or 20% below market value to get the cash in a hurry. Houses are the same. Furniture and hosehold items are worse, you might only get 50% if their value if you had to sell them in a hurry.

I think it is important to take this kind of worst case approach to valuing assets for many reasons. Things like household items are crummy assets. This is because they are almost certain to be worth less next year than they are this year. Ideally your assets should all be growing over time.

This is one of the big differences between the wealthy and the middle class. The middle class take their money and buys services or poor assets like cars, boats, furniture and big houses. The wealthy take their money and buy good assets like stocks, bonds, and rental properties. This brings up the important point that…

All Assets are Not Equal

If you truly want to be wealthy you need to buy good assets. Those items that put money in your pocket over time. A good asset will be worth much more over time than you originally spent on it, as well as any costs you spend to maintain it. Most good assets aren’t much fun while you own them. You can’t water ski behind them, you can’t show them off to the neighbors. They don’t make your life much easier today. But the income or capital gains that they generate over time will grow your net worth making life much easier down the road.
In general buying good assets means putting off your gratification until another day. Instead of buying that PS3 you buy 3 shares of Goldman Sachs. Instead of buying that new living room sofa you purchase 100 shares of Cisco Systems. It won’t be very comfortable to sit on while watching TV, but it will grow your net worth over time instead of just filling up your house.

If you want to be wealthy spend your money on good assets, not on simply acquiring more stuff.

When I talk about money, and my goals, becoming wealthy is right up there. But what is wealthy? Is it having a million dollars? It it having a billion dollars? How will we know when we have acheived it? Let’s think about this some.

It certainly used to be that you had arrived when you could lay claim to the title millionaire, that was enough money so that you could live the rest of your life in style and not worry about running out. When a nice house cost $20,000, a million was a lot of money. But with more and more homes selling for a million dollars, I don’t think having a million dollars in the bank automatically puts you in the wealthy club anymore.

A billion dollars certainly puts you in an elite class. I can’t imagine how I’d ever go through a billion dollars. Heck at a 4% rate of return that billion dollars throws off 40 million dollars a year. Even in Uncle Sam takes half I couldn’t spend money that fast. On the other hand, I can’t see how I’ll ever be worth a billion dollars unless I live to be about 500 years old, which seems unlikely somehow. So while a billion dollars is certainly wealthy, I don’t think you have to get close to that to be wealthy.

I don’t think that being wealthy is a specific number. Robert Kiyosaki had one of the best definitions for wealth that I have seen, he says that you are wealthy when your passive income covers your expenses. For those of you unfamiliar with these terms your expenses are all your money out, everything you currently spend money on. Your passive income is the income your assets produce for you. Of course, most assets do not produce a steady revenue stream, but will vary depending on market conditions. When you can reliably count on the passive income from your assets to produce enough money each month to cover all your expenses you no longer need to work to support yourself. When you have acheived such a state at a level of spending that you are comfortable with, then in my book, you are wealthy.

To me this is the reason to manage your money well, because being wealthy depends not only on your income, but also on your spending. My goal is to become wealthy enough to do what I want with my time, and let my assets produce enough income to support me and my family. I’m getting closer every day, in good years my passive income now exceeds my spending, but in bad years it’s not even close. After 19 years of work I’m on the right side of the power curve headed down hill and hope to acheive that goal in the next 5-10 years. My hope is that by reading this blog you too will become inspired to start yourself on the road to joining the ranks of the wealthy.