Historical article note: This article was originally published on 2018-04-16. Rates, policies, home prices, statistics, product names and qualification standards reflect the environment at that time and may have changed. This archive is for historical record and general education only. It is not mortgage approval, investment, legal or tax advice.
I recently did a radio show, and the response from the audience was very strong. Some listeners gave feedback to the radio station that they could not agree with the guest's argument. The reason was that I quoted a sentence from "Rich Dad Poor Dad": "A house is a liability, not an asset." In fact, this sentence is the most unacceptable to many people when they read this series of books by Robert Kiyosaki. However, I explained it in the radio program that loans for home ownership are liabilities and loans for investment properties are leverage. This is not a word game. The essence of the Rich Dad series of books is to let everyone distinguish the difference between debt and leverage. The situation in Canada and the United States is very similar. When I read this book in China, I didn't understand it very well. It was only after living in North America for several years that I realized the difference between debt and leverage. In fact, the reason is very simple. When a bank approves a loan, it depends on whether the borrower's family has sufficient repayment ability when it affords the next loan. Items included in the bank's debt list are bad debts. Those that generate these bad debts are liabilities, which directly affect the borrowing ability. However, although they are loans, good debts that can be offset by their corresponding income are leverage. Leverage corresponds to assets that can generate income, so it is not counted as a liability.
My daily job is to translate the bank’s language and thinking to loan applicants. The most important concept is debt service ratio, that is, TDSR (Total Debt Service Ratio). When the debt repayment ratio is lower than 44%, the loan will be approved. If it is higher than this number, the loan will be rejected, or the loan amount will be reduced and the down payment will be increased. I introduced how banks determine income in the article "How much tax do you need to file to get a mortgage loan?" The denominator in the solvency measurement method is the borrower's monthly income as determined by the bank. What is a molecule? The numerator is the monthly debt payment of the whole family. The ratio of the numerator divided by the denominator is the TDSR. All items included in the numerator are bad debt. It has been introduced in the "Ranking of Killers on the Way of Mortgage Application", and I will repeat it here. Bad debts include: monthly mortgage payments for home loans, property taxes for homeowners, heating bills for homeowners, monthly car loan payments, monthly student loan payments, and 3% of credit card purchases. When applying for an investment property loan, it can especially be shown that the owner-occupied house is a liability, because in the bank's formula for calculating debt solvency, the monthly expenses of the owner-occupied house are debts, and all expenses of the owner-occupied house directly affect the loan capacity of the investment property. If we regard a family as a company, the asset category in the financial statements should include items that bring income to the family, and the liabilities category should list items that bring expenses to the family. Then the owner-occupied house is a veritable debt. In the eyes of the bank and in the eyes of my rich dad, the view that owning a home is a debt is consistent.
When banks determine the monthly burden of a borrower's debt, they mainly rely on the debt items on their credit history. For example, if you guarantee someone else's car loan, the credit record report will list the balance and monthly payment of the car loan. No matter who is driving the car or whose bank account the car loan is debited from, the bank considers this debt to be the monthly debt payable by the loan applicant and is listed in the numerator of the TDSR calculation formula. On the day the bank accepts the application and checks the credit record report, the amount of credit limit used or the amount of credit card consumption is fixed at a certain number. The bank will include 3% of the occupied/consumption amount as personal debt and included in the numerator. Items that are not listed on the credit history report are usually not counted as debt. For example, although the borrower needs to pay monthly premiums for life or property insurance, but they are not listed on the credit history report, the bank will not include these expenses in the numerator. BUT, the exception is the property tax and heating fee or apartment management fee for the owner-occupied house. Although these expenses are not included in the credit record report, the bank will require the borrower to provide corresponding documents to prove the specific amount of these expenses for the owner-occupied house and include them in the numerator. This requirement once again proves that the owner-occupied house is a debt, not an asset.
To sum up, bad debt affects borrowing ability; bad debt is debt that needs to be repaid with after-tax income; bad debt basically belongs to consumer loans and necessary living expenses; as long as a debt-ridden family is caused by poor consumption management, especially the loan to purchase a home or car that does not match the income.
The problem of bad debt is over. Let's talk a little bit and look at what is good debt and what is leverage. Borrowing money is debt incurred in order to purchase assets that can generate income. It is considered good debt and corresponds to the leverage behavior of borrowing money to purchase assets in order to make a profit. For example, a farm loan to buy a tractor is to provide efficiency. For families, good debt is debt that is paid off with pre-tax income. Specifically, investment home loans. Investment houses have great tax benefits. Investors need to fill out the T776 form when filing taxes every year. Fill in 13 expenses in the form, including loan interest, apartment management fees, and local taxes, which can be used to deduct taxes. The final net income is included in the taxable income for the year. Therefore, good debt is paid off with pre-tax income. The most important point is that when the applicant applies for the next loan, the monthly loan payment of the investment house, land tax, management fee, and heating fee are not included in the numerator of the TDSR formula. The rental income of an investment house is converted according to a certain vacancy rate and then the debt of the house is subtracted. The result is reflected in the denominator of the TDSR formula, that is, adding and subtracting the income item. Therefore, the monthly expenditure on an investment property is not a debt, but a leverage that can be converted into a gain or loss in income for the household from holding the investment property.
I have finished explaining the concepts of debt and leverage. I believe those who can understand understand it now. Those who cannot read these paragraphs may have to retain their stereotypes about debt for the rest of their lives. On a forum, a netizen asked me, if interest rates have risen now, you still advise everyone to increase leverage, you have ulterior motives. Increasing leverage, increasing investment property debt, and taking out cash to accelerate the repayment of home loans or car loans and student loans are shortcuts to reducing bad debt. The CONDOs that many people invested in did not rise from 2010 to 2016, but rose sharply from 2017 to 2018. This is the best time to increase leverage. Investing in properties and adding mortgages can get back the principal invested that year, achieving arbitrage but not leaving the market, and there is no need to pay capital gains tax. The funds obtained from cashing out can be used to reduce bad debts. Bad debt and leverage are two completely different things. People with bad debt are real house slaves. People who use leverage flexibly are people with higher financial intelligence. People who can't tell the difference between bad debt and leverage will either miss investment opportunities or be burdened with debt. People who have not taken the initiative to improve their financial intelligence and cannot listen to new concepts have cognitive biases and reject all concepts that are not in their own judgment knowledge base. If they do not understand, they think it is wrong. Such people's financial situation will not improve. At the same time, they always feel that others are not tired of shouldering the burden, but they do not know or do not want to know why.
A family with an annual income of 100,000 yuan can borrow a mortgage of 4 million yuan without getting tired. I think this is a family that knows how to use financial leverage and has high financial intelligence. However, many people will crudely and disdainfully think of this family as "real estate speculators who will lose their money sooner or later" or "fake documents and fraudulent loans." The differences between people are very small when they are born, but after they break away from the symbiotic state with their parents and establish a symbiotic relationship with health and money, the differences become larger. Some people's annual family income is 100,000, and they are still living in the basement waiting for housing prices to fall. I think the essential difference between these two families with an annual income of 100,000 is the difference in financial IQ. The result of this difference in financial IQ may be a score of 8 houses to 0.
In the past, we often said, "The speed of a train depends entirely on the headband." That's because there were no electric trains before, and the train cars themselves had no power. Now that there are electric trains, this sentence is wrong. Before 2000, there was no word mortgage in China. After it was introduced, everyone only knew about debt, but did not understand that debt and leverage are different. The "Rich Dad Poor Dad" book series has been published for more than 10 years. If you don't understand the truth that "a house is a debt" in China, it's understandable. But if you still don't understand it after immigrating to the United States or Canada, you are out of touch with the times and the environment. Those who cannot distinguish between debt and leverage are already falling behind, and those who fall behind will suffer. Many concepts and concepts must keep pace with the times, otherwise you will not know the reason after being left behind. When you are jumping on the spot and scolding others for speculating in real estate, people with the same income as you have already become your landlord. The investment and financial attributes of houses are not suppressed or restricted in Canada. Instead, they are encouraged by government tax policies. The government uses taxes to encourage investors to buy houses and rent them to others. A very small number of people who lived in the old locomotive era are accusing others of using leverage to buy too many houses. That is because these people have never ridden or heard of a high-speed train, and they turn their grief of falling behind the times into self-moral assertion.
Financial intelligence includes 5 abilities: 1. Make more money, 2. Keep your money, 3. Financial planning, 4. Financial leverage, 5. Improve financial information. Just the difference in financial leverage in the fourth item can widen the asset gap between two families with the same income to as many as eight houses. If there is still a gap in the other four items, the asset gap between the two families when they retire will be huge.