In this fourth installment of the www.planyourescape.ca Personal Finance 101 series we are going to take a closer look at Assets & Liabilities. Our assets - what we own - can be a cornerstone in our personal balance sheet. Our liabilities - what we owe - can be ice on our wings constantly dragging us down. Common wisdom tells us that all assets are good and all liabilities are bad but that isn't always the case. Today we will take a look at the ties between assets and liabilities to help us to understand some key points to consider before we purchase a new asset or take on a new liability.
As you've come to expect in this series of articles, I'd like to start things off with a diagram illustrating the relationship between assets and liabilities.
Now let's get started ...
As we mentioned in the introduction to this article, assets are the things that we own. More specifically, assets are the things that we own that we could sell for money. Some common examples of assets are:
As you no doubt noticed, some of these assets are more valuable than others but they are all considered assets. The value of an asset is the amount of money we could expect to get from selling it today. The value of the asset is not what we paid for it. Some assets can be sold for more than we paid for them and some can only be sold for much less than we paid for them. When an asset goes up in value it is said to have appreciated. When an asset goes down in value it is said to have depreciated. For example, a house tends to have a very stable value and will usually slowly appreciate (go up in value). On the other hand, a computer depreciates (goes down in value) very quickly so that after a couple of years it can only be sold for a fraction of what we paid for it.
Some assets (such as a house) cost more than most of us can afford all at once. So we usually make a down payment and get a mortgage to cover the rest of the cost. We borrow money to allow us to buy the house and we have to pay back this borrowed money over the next 10 to 30 years. This mortgage that we owe is one type of liability. Let's look at liabilities next.
As we stated earlier in this article, liabilities are the things that we owe to others. Liabilities are commonly referred to as debt. Some examples of liabilities include:
Debt usually has an interest charge associated with it. So the amount that you need to pay back is the total amount that you borrowed plus any interest charges. For example, if you borrow $100 at an annual interest rate of 9%, after one year you would owe $109 dollars (i.e. $100 x 1.09). At the end of the second year you would owe $118.81 (i.e. $109 x 1.09). So over time a liability (debt) will increase or, in other words, we will have to pay back more than we borrowed to get rid of a liability. It is important not to disregard the interest rate you pay on a liability because interest charges can add up to significant amounts over time.
We just learned that the value of an asset is the amount of money we can expect to get by selling that asset today, not what we paid for it when we bought it. We also just learned that a liability usually has an interest charge associated with it so over time we end up owing more than we borrowed. Our diagram shows us that assets and liabilities often offset each other. So how can we use this information to help us make better financial decisions?
The number one thing to remember is that if we borrow money to buy an asset, we should use that money to buy an asset that will retain its value or, even better, buy something that will appreciate in value. In other words, we should avoid borrowing money to buy assets that depreciate in value quickly. The second thing to remember is to get the lowest interest rate possible on your debt.
Let's look at an example of buying a $2000 computer using a credit card that charges 18% interest. After 3 years the computer would likely have a value of around $200 dollars. After 3 years at 18% interest, you would owe $3286 on your credit card. So even if you sold your computer to pay your credit card you would still be $3086 short. So you shouldn't do this.
Let's look at a second example of buying a house for $100,000. Let's say you make a down payment of $10,000 and take out a mortgage for $90,000 at 6% interest with a 20 year amortization period (i.e. your payments are calculated to fully pay off the mortgage - including interest - in 20 years). Let's also assume that your house will appreciate in value by 3% each year.
After 5 years of monthly payments, you will have paid just over $25,000 in interest and you will still owe $76,000 on your $90,000 mortgage. Ouch? Not really. After 5 years, your house will have a value of $115,000 up from your purchase price of $100,000. This means that if you sold your house after 5 years,
you would get $115,000 and you would owe the bank $76,000 which would leave you with $29,000 and no liabilities. Not bad.
Well, the key things to remember from all of this are:
And one final thought: taking on debt is OK when used for the purchase of assets that appreciate in value, but it's even better to save the money beforehand and skip the debt altogether. This way, as you are saving, you are earning the interest on your money until you have enough to make your purchase.
I hope you enjoyed this latest installment in the Personal Finance 101 series. Let me know if you have any comments or questions by leaving a comment below.
This article is part of the Personal Finance 101 series.