I continue to find people who believe their house is their "best investment". If you are one of those people, this post is for you.

Assets, Liabilities and Ownership

This post is about investments but the definition of an investment is closely tied to the idea of an asset.

Im sure you have heard these terms before. An asset is something you own that is worth money. A liability is money you owe to someone else. The difference between the two (assets - liabilities) is what you actually "own". (It is also called net worth.)

We commonly say that we "own" a house, but the sad truth is that most people dont really own much. Let's say you bought a $100,000 house and you have a mortgage on the house for $75,000. In truth, you only "own" a $25,000 house ($100-75 = $25) -- the bank owns the rest.

The trouble with assets and liabilities is that the value of an asset changes and can change suddenly and dramatically, while the value of a liability only changes when you pay it off, which is to say slowly. Moreover the value of a asset is not what you paid for it but rather what someone else is willing and able to pay you for it.

We tend to see the most dramatic asset changes in times of war but they happen all the time. In war times fortunes are won and lost because the willingness and ability of people to pay changes dramatically. Picture the price of real estate in downtown Warsaw just after Hitler invaded Poland and you get the idea. Or picture the price of real estate in Detroit today as GM and Delphi fire thousands of people.

The reason this is a problem is because the value of your asset can drop below the value of your liability and that leads to bankruptcy. Imagine you lost your job and you need to sell your house and move but the only buyers are willing to pay $60,000. Not only has your $25,000 asset disappeared but after you give the bank the $60,000, you still owe them $15,000! ($60,000 - $75,000 = -$15,000) Ouch - negative net worth is not fun.

Investment

So what is an investment? An investment is an asset that generates cash income every month and increases in total value over time.

It is a pretty simple definition really but people dont seem to think about it much. Given a house, a car and a rental property - which one is an investment?

Expense

An expense is basically anything you purchase that is not an investment. The vast majority of our purchases are expenses.

Expenses sometimes seem like assets (they are worth something) but they arent investments because they dont generate income nor do they increase in value. This is hard for many to swallow because a car today can cost as much as the our parents' first house did. Even so, if it doesn't satisfy the definition of an investment it is an expense no matter how much it cost. A car, a PC, a TV - these items are all worth less every day we own them and they never generate income.

In terms of personal finances, it is ok to use a loan (a liability) to purchase an investment but it is not ok to use a loan to purchase an expense. If you cannot afford to pay cash or pay it off quickly, then that expense is too expensive for you.

This is a pretty simple rule that the WW2 generation followed and we have lost completely because it takes willpower (and they didnt have credit cards). If you buy something on a credit card, you dont really "own" it until you pay off that liability (the credit card). If you cannot pay it off in full within 30 to 90 days, then you are spending more than you can afford. Dont complicate the issue with talk of interest rates or loan terms. If you cannot pay it off, you cannot afford it so move along. (The reason it is easier than ever today to borrow money is because lending money is a terrific business, not because you "deserve it".)

Savings

So what about a house? A house is worth a lot of money and it generally appreciates in value. Why isn't a house an investment?

The reason a house is not an investment is because it does not generate income. A house is an asset but not an investment.

You need a place to live so a house satisfies your need for housing. In this sense, it acts like an expense the same as rent would. The problem with thinking of a house as an investment is that you cannot get money from a house until you sell it and if you sell your house, where will you live? (Getting a 2nd mortgage on your "equity" is the same as selling your house, you are just selling it to the bank who will let you live in it as long as you pay them. The bank creates a liability against your house and your net worth will go down.)

Think of your house as a savings account not an investment. The general wisdom is that it is "better to pay a mortgage than pay rent" but it isn't that simple. (People say you can pay rent or you can pay yourself, but think about it. You cannot really pay yourself. Real income is money from other people.) First off, most of your monthly mortgage payment for many years is really just a fee to the bank; only a part of your payment pays off your liability. Over time you do pay off the liability on your house (assuming you do not refinance), which means you own more of that home asset but it is more appropriate to think of your house as a savings account. You put money into it over time like a piggy bank bank but you dont get that money until you smash piggy.

Rent or buy?

It is essential that you save money for your future but there is no reason to disparage renters with this smug idea that you are more responsible because you are investing in your house. Renting and buying both make sense depending on the economics of the situation and anyone who says otherwise doesnt understand investing. To decide which course is best from a financial perspective, you need to compare your future net worth if you had bought versus paying rent and investing the monthly difference in an investment. It's not a trivial exercise.

It is healthier to think of a house as savings account and to decide whether or not to buy a house based on whether you really want to own a house. (Too many people feel pressured to own a house because of this wrong-headed belief that it is the responsible thing to do.) If you do buy a house, pay off your mortgage so that you own the whole thing. Either way you also need to save money and put it into a real investment - one with cash flow and appreciation.

If you buy a second house and rent that, then you have an investment. The critical piece here is that you rent it and get money from someone else. (If you buy a vacation house and dont rent it, you again have an asset but not an investment.) If you buy the rental property correctly, you will get more rental income every month than it costs to pay for the property which means you will have monthly income with an asset that increases in value. A rental property is an investment.

Speculation

Given a house, a car and a rental property - which one is an investment?

The only investment here is the rental property, and even there its only an investment if it makes money every month (called "cash flow positive"). If you paid more to buy it than you can rent it for, you are "upside down" and on the way to bankruptcy.

Recent events have given us very cheap money, banks that are falling all over themselves to make loans, and rapidly rising home prices. A lot of people are "upside down" every month but believe they are investing because they will make a killing on the value of the property when it goes up. Unfortunately these people are not investing, they are speculating. I fear a lot of them are going to find out the difference the hard way - in bankruptcy.

good luck

I know this is a difficult issue to discuss because people know they should invest but they dont really understand what that means. This makes people nervous and emotional and defensive which in turn makes it hard to talk about. But I hope you will think about what I have said and talk to others about it. Just be aware that there are a LOT of people who's income depends on selling houses to people who think they are investing so take everyone's input with a grain of salt. And dont be swayed by the masses not to form your own opinion. The vast majority of people misunderstand capitalism and make poor choices time and time again.