"Ask Robert" March 2011 - Answer
As always, I want to thank everyone for great questions. It's always hard to pick just one, but that's the rules, so here goes.
This month's question comes from Chris K.
Robert, You have always said that buying a house for yourself is not an asset, but rather a liability. I understand that cash flow is most important, but if I were to buy a house now for my family with 100 percent cash (Approximately 300K), I figure that I would be making a positive cash flow by saving 2K per month in expenses (mortgage). Is this not as good as buying an investment property that cash flows at 2K per month? A penny saved is a penny earned right? Am I missing something? Please advise what you think.
As I said, there were many good questions this month. Many of them were on very technical aspects of the market. I picked Chris's question because it is probably something most people would struggle with and can identify with.
Also, Chris's question is an example of the traps you can fall in when not fully thinking through all the costs and possible revenue sources of an investment, and a good example of the problem with old rules of money embodied in phrases like, "A penny saved is a penny earned."
First off, I want to point out that the absence of an expense does not equal income. Not paying $2,000 per month in a mortgage is not the same as making $2,000 a month from a rental property. All it means is that your income, wherever it comes from, is free for other things. In this case, if the income came from a job, it would be an income that is taxed at the highest rate and a result of a job from which you have no control over. That's the worst form of income. It's earned income rather than passive income.
I'll go back to my rich dad's very simple definition of an asset. An asset is something that puts money in your pocket. In this case, paying $300,000 out of pocket does not give you an asset that puts money in your pocket. It gives you a house that you've paid for. The income going into your pocket comes from somewhere else, and if it's from a job, it's at a very steep cost—the vast majority of the hours in your day and high tax rates.
Also, rich dad's definition of a liability is something that takes money out of your pocket. In this case, the house is still a liability because you have to pay property taxes, take care of maintenance costs, pay for electricity and water, cover the cost of insurance, and more. All this on top of the $300,000 you dished out of pocket.
That being said, having an extra $2,000 a month because you've reduced expenses can be a great opportunity to invest in things that do create cash flow. However, a majority of people would either spend that money on other liabilities like cars or television, or put it in the bank as savings.
The problem with the first scenario is that when retirement comes, you'll have a bunch of obsolete liabilities and no income producing assets. Your source of income, your job, is gone.
The problem with the second scenario is that in an economy where money is printed out of thin air, a penny saved is not a penny earned. Over time, inflation eats away at the value of your "pennies" till they're nearly worthless.
What is more, I'd say that the cost of laying down $300,000 to get $2,000 a month less in expenses, while still having to cover the costs of your house out of pocket, isn't the best strategy. Here's why.
One of the reason's why I love real estate investing is because I don't have to pay one hundred percent of the price but I still enjoy one hundred percent of the benefits.
When I find a good real estate investment, I can go to the bank and get a loan for 80 percent of the purchase price. I then only have to put down 20 percent of my own money—or investor's money, if it's a good enough deal. And even though the bank is fronting 80 percent of the costs, I get all the rent and appreciation, if there is any. All the bank wants is the interest.
If I've found the right deal, a cash flowing deal, this is a win for me because my renters will pay for the costs of the property, including the mortgage. Additionally, I enjoy tax benefits from the property such as depreciation that make my return even higher, and the income from the property is taxed at the lowest rate because it is passive income.
So, the win for me is simple. I pay less out of pocket initially, have no monthly expenses, and have more money left in my pocket for other investments. While this is not as initially exciting or sexy as having freed up $2,000 a month in expenses, it's the path to true long-term wealth and financial freedom. The more investments I'm able to do like this, the more cash flow I'll have from assets that actually, tangibly put money in my pocket each month while costing me nothing out of pocket. And when it comes time to retire, I'll have a portfolio of solid, cash flowing investments that work for me, not the other way around.