Wednesday, March 19, 2008

What one must do?

Your question “what one must do?” is unfortunately being asked after the water has already passed under the bridge. The house is bought, interest rate has ballooned, equity has vanished as the house has lost more than 15% in value, and new loan standards are more stringent than of old, so a second loan isn’t possible. Right now all you can do is cut down all other expenses, take a second job and pay your bills, so you don’t lose your house. However, the correct approach, I feel is given by Robert Kiyosaki in his best seller “Rich Dad, Poor Dad”.It talks about 2 approaches to money.

Case 1- Is a guy earning, let’s say, 100K. He is a prudent guy, got a wife, 2kids, a dog and a house in Westchester. Wife works part time and also gets an additional 25K. Unfortunately even after grossing 125K, this family has no savings. Not because of lack of prudence. Where does he cut?
1) His house? He lives in a 3 bedroom apartment. He either lives here in a good school district and pays a premium for housing or goes to a cheaper area but pays private school fees.
2) They go out once a week as a family. Kids need outings.
3) They take once a year small week off vacation. Again, kids need a break.
4) All other expenses are on the kids incidentals. From new toys, to clothes, to school trips. You cant really cut out anything.
5) They have one decent van which is needed to ferry the kids around.
6) Both commute to work using public transport
7) They shop at Costco to save on household expenses.

So in short they do everything they can. But are still not saving. This is called the expense approach. This family has fixed income, fixed expense, no income generating asset. Now let’s talk about

Case 2 This is a guy who has planned his expenses before they incur.His planning started 12 years ago when he started earning money. That time his expenses were minimal. Lived with a roommate and paid 400$ as rent, basically after all incidentals, his total spending was 1000$ a month.Rest of the money he started putting away in income generating assets.This guy started at 50K, after all taxes and expenses, at the end of the year, he saved about 25K which he used as a 20% down payment on a small investment apartment which generated enough rent to cover payments on a mortgage and maintenance. A couple of years later he married and they decided to buy a small apartment with a larger down payment with the savings of both. Both of them worked full time and they earned total about 100K. They made sure that one income was sufficient to cover the mortgage of the apt they lived in and their other expenses, so that they could use the other income for investing.They always treated their primary residence as a non income generating asset and always looked out for investment opportunities which generated long term income.They invested some in stocks, some in other rental properties and slowly over next five years they built up an asset portfolio.They were now ready for a baby.Their assets were now generating a positive cash flow of around 2000$ a month so they decided to buy another larger primary residence after selling the old, putting the entire equity of the old house (which was sizable as they had bought with large % down+ they were paying down some principal over 5 years + there was a small upward valuation in their value) into a large % down payment of the new home so that their net mortgage + maintenance worked out to only $2000 monthly.They knew the wife would stop working so they didn’t want the house to become a burden. They were paying for this non performing asset using the net cash flow of the performing assets.The husband’s income was growing and they were still able to save money, which they continued to invest in either their other assets or bought new performing assets.They always planned for their expenses, (a kid is an expense) and made sure they didn’t commit to an expense till they had income generating for it. This is in gist what this guy talks about in his book.
1) Understand the difference in performing and non performing assets.
2) Strive towards building a performing asset portfolio
3) Commit to expenditure only off income generated through your performing assets
4) Use your primary income (your salary or your business) to buy other performing assets.
5) Treat your non performing asset as a liability and expenditure.

Your primary residence is an example of this. This is the way to not get into the trap of what you ask. All this is doable. But you must have a correct approach to money. Expenses are bound to happen, you can’t stop them. We work hard to live well. We all moved from our homeland to America to live better.So why stop spending? Instead, decide on what you want to spend, and think about ways to generate income so that you can continue spending and living the way you want to.
I am a complete consumerist and a capitalist at heart. So take what I write, accordingly.

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