I got into an interesting conversation with a commenter the other day on another blog and it made me realize that there are some people out there who don’t actually understand some of the basics of Personal Finance. I don’t talk about the basics to often on My Journey to Millions, because quite frankly, how hard is it to understand spend less than you earn? However, this conversation (and subsequently wanting to throw my computer out the window) inspired me to write a post about about a twist some may not understand in the basic balance sheet/net worth statement.
A little background is in order. My fellow personal finance blogger, Ninja, from Punch Debt in the Face recently took on the topic of whether he prefers a 15 or 30 year mortgage (a topic I covered in the early days of this blog). Side note: I thought it was interesting we came to the same conclusion despite his stick figure drawing abilities and hatred of alcohol while, I on the other hand am so untalented that I can’t draw stick figures and I love me a good drink. It was the during the course of 50 or so comments (post is up to 91) that a reader named “C” emerged.
C, is an angry commenter (I have my fair share) who decided buying a house wasn’t for her, and since we all know personal finance is personal I am all about listening to all sides of an argument if they are logical and coherent. Well, you can probably tell from my tone, C was anything but that. She was so irate and close minded I had to guess as to the essence of C:
ME: Can I take a guess at the essence of C, without you being insulted? Single, young (22 to 26), underemployed (you have some income but you aren’t doing what you want) and you think you deserve more from life? Am I close.
HER: I’m 27.
I nearly pissed myself laughing when I saw that response. It sucks she was so irate, close minded and to be quiet honest an idiot because if she stopped feeling sorry for herself for one second the conversation may have opened up to something really interesting. Specifically, whether a home should be someone’s goal…ah such is life we need some people to bring down the curve.
But I digress.
Buying a Home or Any Asset with a Mortgage or Other Note Doesn’t Change Your Net Worth
One of the aspects of personal finance she didn’t understand is why when one buys a home with a mortgage, or if someone buys a business with a note why their net worth doesn’t necessarily change. Let’s take John Doe’s balance sheet (it will be a little simpler than than this high net worth balance sheet that made me feel inspired):
- He has saved a nice down payment of $50,000
- Has other assets (retirement funds, grandma’s cash, etc. etc.) of $15,000
- Credit Card Debt of $5,000
His net worth is easy to calculate he has $65,000 worth of assets and $5,000 of liabilities, or a net worth of $60,000.
Lets say if he goes and buys a home for $250,000 using his $50,000 as a 20% down payment (we will ignore fees for purposes of this exercise):
- A Home worth $250,000
- Other assets of $15,000
- Credit Card Debt of $5,000
- Mortgage of $200,000
What is his net worth? His assets are $265,000 (home + other assets) and his liabilities are $205,000 leading to a net worth of $60,000. The exact same amount!
Why Doesn’t Taking on Debt Doesn’t Always Reduce Your Net Worth
At this point it should be pretty self evident, but the reason is that there is a corresponding asset on the other side of the balance sheet. If our made up individual decided to take his credit cards and buy something other than an asset then those liabilities would obviously have a detrimental affect to his net worth statement.
When I explained this to my muse her question was what if the house goes down? Well, then yes so would his net worth statement, but at the same time what if your grandmother had balls? She would be your grandfather. Of course there is risk in buying anything, but it is no different than buying stocks and people seem to have no problem in understanding that stocks have risk, but why should a home? But now I am going on a different tangent.
In the short term (i.e. that same day) in your net worth doesn’t change when you buy a house with a mortgage or a business with a note because there is a corresponding asset on the other side of the liability. The power/risk presents itself when the liability stays the same (and goes down over time) while the asset increases or decreases over time.
Did you ever believe that taking on a mortgage would hurt your net worth in the short term? Or is that something you learned a long the way?