Most discussions of investing and personal finance address a specific situation or technique. While such a level of detail is important, many people are incapable of utilizing this advice within the context of their own needs and circumstances. Often a collection of unrelated decisions or actions creates unanticipated inefficiencies, conflicts or risks.
What’s missing is a basic, guiding principle. One fundamental financial rule can be used by everyone from complex financial institutions to the average consumer – matching liabilities (your obligations, debts or needs) with assets (investments, savings or resources).
The beauty of this principle, aside from its simplicity, is that it applies to both borrowing and saving. In borrowing, the length of a loan should not exceed the useful life of the thing purchased with the loan, and items without lasting value should be paid for rather than financed. This means that long-term loans should only be used for purchases that have lasting, or even increasing, value.
Real estate and education are the only expenditures that have proven to increase in value over time. The recent real estate frenzy notwithstanding, real estate has increased in value at slightly more than the rate of inflation, and it provides shelter along the way. And despite the high cost of a college degree, the benefits are even more substantial. The average worker with a bachelor’s degree earns almost $18,000 more annually than a worker with a high school diploma, a master’s degree adds $8,000 more and a doctorate earns roughly two and a half times what a high school diploma will. Over their entire working lives, a college graduate will earn about $1 million more than high school graduates. A home and higher education are well worth taking on long-term debt.
What about borrowing to invest, since a diversified portfolio can be expected to increase over time? The short-term volatility of most investments makes this a risky strategy, since a decline in the portfolio could force you to liquidate at the worst possible time.
Nearly all other purchases either decline in value over time, like cars, or their increase in value is uncertain, like art or collectibles, so the term of any loan is critical. It is also important to avoid loan amounts that can exceed the declining value of the asset.
Of course, carrying a credit card balance for everyday purchases like food, clothing and other disposable items flies in the face of asset-liability matching. Using credit cards for convenience only and paying balances in full not only preserves your borrowing capacity for more appropriate purchases but also helps enforce disciplined spending.
This concept also casts a shadow on the common practice of rolling debt into a refinanced mortgage, or taking cash out of a refinance to go on vacation or buy disposable items. The pitch, of course, is that monthly payments will be lower, mortgage debt can lock in low rates and there are tax advantages. But over the long term, the total borrowing costs will be much higher, and ask yourself the simple question – do I really want to be paying for my vacation for the next 30 years? A far better solution is to bite the bullet to pay off those purchases and use consolidation as a last resort.
In saving, the trick is to fairly estimate the future obligation or need and develop a plan to create the assets to meet that need. Many of those future needs, such as a growing family, can be met out of current income with proper budgeting. Other needs, such as education, can be met through a combination of saving and borrowing.
The big liability that will impact almost everyone is retirement. For those few who have saved enough to make a more exact analysis worthwhile, financial advisors or readily available tools can project how long savings will last given spending levels. But for the most part, Americans are either completely clueless or stubbornly overconfident that their retirement income needs will somehow magically be met, despite longer life spans and the trend of more years spent in retirement.
While nearly 70% of Americans are either very or somewhat confident they will have enough money to live comfortably in retirement, more than half of workers over the age of 45 have less than $50,000 saved for retirement, and 30% of workers believe they will need savings of less than $250,000 for a comfortable retirement. Not surprisingly, the method of 44% of workers for determining their retirement needs is a “guess”. Clearly, there is a major disconnect between the financial liability of retirement and the assets needed to meet it.
So many things that we purchase – a car, a vacation, a fine meal, a gift – have legitimate emotional value, and this is the value that often leads to a heavy debt burden. By remembering to match your assets with your liabilities as much as possible, you will have much greater control of your finances and will enjoy the freedom it brings.