This article originally appeared in the December 2012 Newsletter.
If you think that the type of house one lives in or car one drives is a good indicator of their financial wealth, then you likely have an underdeveloped understanding of personal finance matters. Your ability to perceive wealth matters to your future because if your perception is not congruent with reality, then the likelihood you will stumble down a flawed financial path will be greater than it otherwise would be.
Why aren’t homes and cars good indicators of wealth? To answer this question, you must understand the nature of a house (primary residence) or car. Housing and cars serve a basic need in life; shelter and transportation. To get through life and succeed, all of us need both, but the threshold is pretty low. For example, an old car that has a bad paint job and a number of dents is a good source of transportation, if it doesn’t mechanically fail. Most people don’t opt for this baseline level of automobile transportation. The point is that after a certain minimum is reached, housing and cars become more of a luxury than a utility.
Luxury items are a liability, while utility items are an asset. Living in a 4,000 square foot home and owing a Mercedes are big liabilities. These items become even bigger liabilities when they are financed through debt. Debt must be serviced regularly, which normally means monthly payments. Monthly payments reduce ones disposable income available, which translates into fewer choices when either buying goods/services and/or investing.
Cars depreciate over time, especially when new, and need routine maintenance, gas to run and insurance coverage. Historically homes do not depreciate in value, but do require routine maintenance, and also require insurance. These facts are not items that lead to greater wealth, but a deterioration of wealth.
Ultimately, what people are aiming to gauge through the car one drives or house one lives in is the standard of living a person can secure given their current free cash flow. The more relevant question in terms of gauging wealth via an automobile and/or house is how much of their monthly free cash flow is committed to serving debt and other regular maintenance on a car or house.
What lies beneath the surface is hard to see and know. This is the problem when gauging wealth based on an automobile and house. Both do not generate wealth, though both are looked at in terms of a measure of wealth. Understanding this connection can go a long way in terms of clarifying your personal finance thought process.