Rich Dad’s Definition
In the book Rich Dad Poor Dad, Robert Kiyosaki defines “asset” as anything that puts money in your pocket. “Liability” is anything that takes money out of your pocket.
For example, is an owner-occupied home considered an asset or liability? Since it is taking money out of your pocket, Robert says it is a liability.
Then how about a property that you bought and being occupied by tenants. Is it an asset or liability? Because it is generating income for you, Rich Dad defines that as an asset.
For many years, I blindly followed that definition, until one day when my good friend Peter Lim pointed out a misconception, a flaw in Rich Dad’s definition. I suddenly have much more clarity about the meaning of assets and debts, and how it is good or bad.
Let’s use an example to illustrate the point:
- Rental property: $3,500 a month
- Mortgage: $500,000
- Tenure: 35 years
- Monthly installment: $2,300
- Maintenance & tax: $700 / month
- Positive cash flow: $500/month positive cash flow
The property is an asset since it provides cash flow
In a different scenario, with the exact same property, but a much shorter loan tenure, only ten years.
It increases the installment to $5100/month.
Now the same property is in a negative cash flow situation
- Rental: $3,500
- Maintenance & tax: $700
- Installment: $5,100
- Negative cash flow: $2,300/month
If liability is something that takes money out of your pocket, this exact same property has just become a liability. But fundamentally, nothing changes on the property. The only difference is how we finance the purchase.
Defining Assets
In accounting, assets are something that has monetary value. We can categorise assets as good or bad, depending on how their value changes over time.
Good Assets
- Generate income
- Appreciate in value
- Example: rental properties, Apple stocks
Bad Assets
- Incur expense
- Depreciate in value
- Example: cars, gaming consoles, iPhone
Before we move on to define good debts vs bad debts, here is a disclaimer:
The idea I share here is unconventional and might contradict what you believe. Please don’t follow blindly and don’t hold us accountable for your action. This is not professional advice. All illustrations are for educational purposes only.
Defining Debts
In accounting, debt is money owed, and we usually need to pay a specific interest rate for borrowing that money.
For debts, I categorise it as:
Good Debts: Low interest
Bad Debts: High interest
You might ask, how low is low? And how high is considered high?
The benchmark should be the return rate you can conservatively get elsewhere.
If you have a big chunk of your money in Fixed Deposit earning less than 2% a year, any interest rate higher than that is high in your standard.
As for me, I am a long term investor in stocks and properties expecting an average double-digit annualised return over the long time horizon. So my standard of the interest rate that I can stomach is a little higher. I would consider financing costs that are less than 5% as low.
My point is to define assets and debts separately. You can buy good assets with good debts or bad debts. Or someone might purchase bad assets with good debts, or worse, using bad debts.
Examples
Let’s look at a few common examples:
Apple stock has appreciated 3,500x for the past decades, plus a lot of dividends along the way. No doubt that it is a good asset. On top of buying it with your cash, you could also borrow margin financing to purchase it, paying interest of 1%-5%. That is good debt, not because Apple stock is a good asset. It is because the interest rate is low.
The following example is purchasing a rental property. The property itself is a good asset when it produces stable rental income, and appreciates over time. But what if you bought a property that couldn’t attract tenants for an extended period? Moreover, due to the wrong location and low demand, its prices might even fall. Then the property is considered a bad asset.
However, you could finance it with a low-interest mortgage of around 3%-4%. The debt is still regarded as good in my standard because of the low-interest rate. But bear in mind that how you finance the property purchase hasn’t changed the quality of the asset. Whether you buy it with cash or borrowed funds, the piece of real estate that couldn’t generate rental income and didn’t appreciate after many years is still a bad asset.
One more example, I purchased an iPhone with a 24-month instalment plan, financed with my Apple Card, without interest. A smartphone is a bad asset since it will lose its value roughly 50% after two years. But my debt incurred is good because that is zero interest. There is no cost of financing at all.
Summary
In conclusion, I absolutely agree with my friend Peter Lim who brought this idea to my attention. We should look at assets and debts separately.
Whether an asset is good or bad, depends on the asset’s quality. Will it have good potential to appreciate and churn out income for you non-stop?
You would want to convert your cash into good assets as much as you can.
On the other hand, how do you pay for the assets is a separate story. Do you pay for it with your cash on hand, or finance it with debts? Debt is good when the interest rate is low in your standard. Debt is terrible when the financing cost easily beats the return rate you can command elsewhere, e.g. credit card debt is disastrous because the interest rate could be 18% or more.
To accumulate wealth effectively, acquire more good assets. And don’t shy away from using good debts to do so.
Please post in the comment, sharing one of your debts. Based on the idea in here, do you think the asset you acquire is good or bad? And the debt is it good or bad?
Be smarter with money!
