Last week, I introduced you to a new (very short) series on how to be very wealthy at any income. That article focused on making compound interest work for you rather than against you.
It makes a huge difference. Over 50 years, earning a conservative 5% interest means you’d turn one dollar to $11.50. So you could turn 90,000 into over a million dollars. Conversely, you could be paying 10% interest (or more) on a credit card. If you can make one dollar grow to more than $11 in 50 years, how much do you think the credit card companies can make at twice (or more) the same interest rate? I started to do this calculation and the numbers got so ugly that I didn’t trust my math. (It was essentially that you have to make $117 to pay off each dollar of debt you created… and it was 10 times worse when paying 15% interest.)
Of course few people plan ahead 50 years. That’s not really the point.
The idea was that you can turn a dollar into more than $11 or turn more than a hundred dollars into a single dollar. If I gave you a million dollars today, would you rather have more than $11 million or less than $10,000?
Ahh, but compound interest was (literally) so last week.
Let’s turn our attention to something new: assets and liabilities.
Before I go any further, I have to give some credit to where it is due. This concept was brought to my attention by reading Rich Dad, Poor Dad by Robert Kiyosaki. While the book inspired me, the only useful I learned was this explained in pages 69-70 (of my copy, your edition may differ.) Other than this, I think Kiyosaki is selling a bunch of misinformation. Does it count as “giving credit” if I (and many others) believe the person is a fraud?
The concept was that people who are rich buy assets that appreciate in value. People who are poor spend their money on liabilities.
Let’s take an example of two people: Asset Man and Liability Man. (If you thought I was going to in a “fatherly” direction there, you were very close to being right).
Liability Man spends $60,000 to buy a luxury SUV. He enjoys it for four years and decides he wants another new car because he just loves that smell. We don’t need to get into that new purchase. Let’s just focus that his luxury SUV is now worth only $30,000.
Asset Man decides to buy a Subaru Forester for around $25,000. It has the same new car smell. He uses another $35,000 to put a down payment on a $150,000 investment property. The tenant pays the mortgage and the property goes up in value over time (real estate is an appreciating asset). The property appreciates an average of 4% a year for 15 years and becomes worth $270,000. The mortgage is down to around $70,000.
Liability Man turned his $60,000 into $30,000. Asset Man turned turned his $60,000 into $200,000. That $200,000 comes from the $270,000 value of the property minus the $70,000 mortgage. Yes, that’s 15 years away, but wouldn’t you want $200,000 in 15 years? (Who would say no to that?) Also, the Forester he bought is worth around $12,500 after the same 4 years as Liability Man.
These numbers are estimated, but hopefully you can see what’s happening. Asset Man is building wealth. Liability Man may be enjoying life, but he’s not building wealth. In 15 years Asset Man might decide to sell that investment property and use that $200,000 to buy a luxury SUV AND 3 more investment properties. Those properties might provide enough cash flow to fund his entire retirement.
That’s not bad for a single buying decision over four years. Imagine if the decision was to buy a used Forester at $10,000 and the remaining $50,000 was invested? Imagine what you could do if you lived a lifestyle that was focused on spending money on appreciating assets.
This scenario is very similar to the compound interest point that I made above. Your money can grow or it can shrink. It’s up to you to make the choices that are right for you. My general focus is on acquiring assets that appreciate because financial freedom is important to me.*
Unfortunately, appreciating assets can be very boring. I don’t know too many people that think, “I’d love to be a landlord and get calls about pipes bursting at 3AM!” (You can get a property manager – don’t let this scare you away.) Only a nut like me thinks, “Oh, a few more shares of IBM will make so happy!” (Okay, I’m not even nutty enough for that.) It’s difficult, but the idea is to focus on the big picture.
Spending money on liabilities that depreciate is a necessary fact of life. You notice that I didn’t suggest that people should just not buy cars. That’s possible for some, but not for others.
It’s a balance. If you can tip the scales towards buying assets, I think you’ll find yourself fairly wealthy in a decade or two.
* That doesn’t mean we can’t splurge every now again. In fact, we bought a luxury SUV.