Wednesday, December 16, 2009

Why do the Rich Get Richer?

I am sure that everyone has heard this line before: “The rich get richer while the poor get poorer.” Whether this comment is fact or fiction is a matter of opinion. Many self-made millionaires were once arguably “poor.” A number of “rich” people have also become poor, especially if they did not create their own wealth. That said, why is it that rich people like Donald Trump can go from broke to billionaire more than once while many people cannot seem to get past living paycheck to paycheck?One big reason is that rich people buy assets; poor and middle class people buy liabilities. The really rich buy assets with other people's money but that's a topic for another day.

Personally, I like the definition for both give by Robert T. Kiyosaki. Assets put money in your pocket; liabilities take money out of your pocket (or use cash). I received a letter the other day from my bank encouraging me to increase the limit on my secured line of credit. This letter from one of our big Canadian banks suggested that I could use the extra money to “renovate [my] kitchen, consolidate debt, or take the family on that much-needed winter vacation!” No wonder most of us get poorer. Even our esteemed banks that we look to for financial advice encourage us to get into debt so that we can buy liabilities!

Meanwhile, what do rich people like Warren Buffet, Donald Trump, and Robert Kiyosaki do that the poor and middle class don’t? While the general public punches the clock trading time for money so they can pay back that vacation (with interest!), the rich buy assets like stocks, businesses, and real estate. They make their money work for them instead of working for their money.

This strategy is not just for the rich. You and I can do it too. I know that it can be scary, especially since we were never really taught this concept in school. As kids, weren’t our parents always telling us to work hard to get good grades and a safe, secure job? Did your dad or teacher ever tell you how to buy a property or a business and let the investment pay for itself? If so, you are definitely one of the lucky few.

Not all debt is created equal. Good debt is where you borrow other people’s money and use it to create wealth. Bad debt drains your cash and forces you to work harder to pay it back. As an added bonus, the government generally allows you to write off interest when you borrow to purchase assets making your loan even less expensive. Be sure to talk to your accountant before making any assumptions though, and never make an investment purely for tax savings. After all, your goal is investing to make money – not lose it!

Personally, I would argue that debt to acquire a property that does not produce positive cash flow is NOT good debt (it takes money out of your pocket). How many of these properties could you afford to own? Negative cash flow can eat you alive! On the other hand, if you borrow to purchase a property that gives you a small amount of money in your bank account after all bills are paid each month, how many of these properties could you afford! As many as you can get! Negative cash flow can also force you to sell your “asset” at the worst possible time if you cannot afford to keep it. If you have positive cash flow each month (assuming you want to sell), you can afford to wait as long as you want to hold out for a better offer.

Do you have a plan that transitions you from working for your money to your money working for you?