Some time ago, I came across an amusing conversation in AIFW. It was on – Buying a House vs invest the EMI amount in the mutual fund. It was amusing for me because Pattu Sir and Ashal too got taught about investing in that thread. Well, that’s typical bull market thing. The comparison also amused me because everyone was assuming the EMI as an expense (it is more than that) and investing as good outflows (No, It is just taking money from the right hand and putting it in left). Since the discussion was going on a flawed track of Income – Expense accounting (Most common way of accounting used by financially illiterate folks) I thought about throwing a spanner in that calculations.
The 5 Actors of Personal Finance
The biggest mistake that financially illiterate do is to see everything in terms of incomes and expenses and view things as single entry accounting scheme (PS: I hate this thing). This leads to financial myopia. In this scheme, the liabilities are seen as incomes when received and its EMI as an expense. This blinds one from the current balance of a liability. The manifestation of this is spiraling credit card debt. For them, the interest expense is invisible causing either total ignorance of it or social media overreaction (You get to see it in AIFW). This myopic view also leads to thinking investments as incomes. This myopic view is called as Income – Expense accounting. The proliferation of personal finance apps is the reason for this single entry income – expense accounting to hold even today.
The actual finances, whether its country, or a company or a person has 5 actors running the show. They are
- Net Worth / Equity / Capital / Your Money (pick any as you wish),
- Income, and
[See Also: Double Entry Accounting & Personal Finance]
In this 5 actor view, it becomes imperative to record every transaction as affecting 2 accounts. The ‘from’ account gets credited and the ‘to’ account gets debited. For example, if you buy vegetables worth Rs. 150 and pay by debit card the accounting entry would look like
Dr. Expense: Groceries – ₹ 150
Cr. Asset: Current Asset: Bank – ₹ 150
To visualize this – the money from the bank is going to fund the expense. This helps you in identifying account which is funding an expense as well as totals of expense immediately. Suppose the same transaction is done with credit card, then the bank part would be replaced by the credit card.
Dr. Expense: Groceries – ₹ 150
Cr. Liabilities: Current Liability: Credit Card – ₹ 150
but in the second case, the Liability Increased due to credit entry whereas the asset decreased due to it. It’s because of the accounting equation.
Assets = Liabilities + Net Worth
Net Worth (dummy store only account) = Asset – Liability
- The assets increase in value when you put more money into them.
- Liabilities increase in value when you take money from them.
- The Net Worth is nothing but the Difference between Asset and Liability.
- The Expenses are always Debited and Incomes are always credited.
- Expenses get credited only to show discounts like Cashback etc..
- Income is debited in case of erroneous entries.
The Big Picture of buying a House
Before we jump into the debate of Buying a House vs Investing we should note that the concept of OPM comes into the picture. OPM stands for Other People’s Money and a high falutin version of it called as Liability. Liability is outside money and when its used for asset purchases it expands the monetary base. Once the payment begins, the Net Worth starts expanding.
While buying a house – Bank lends a certain amount and asks us to cough up the rest. The Bank Loan will be a liability, House will be an asset as money is flowing into it. The money coughed up by us will be in our bank account itself, hence its also an asset. For example, consider you have 20 Lakhs in Bank Account and want to purchase a house worth 30 Lakhs. Since you don’t want to run out of Money while buying a house, hence you take a loan of 20 Lakhs.
Before buying the house your accounting equation will look like this.
Assets (Bank: 20 Lakhs) = Liability (₹ 0) + Net Worth (20 Lakhs)
After buying the house the accounting equation would turn into
Assets (House: 30 Lakhs + Bank: 10 Lakhs) = Liability (Loan: 20 Lakhs) + Net Worth (20 Lakhs)
In the above equation, the presence of liability created value out of thin air. Before the liability, the total assets were 20 Lakhs, Once the liability came in the asset value increased to 40 Lakhs. But the arrival of liability also increased the risk, the risk of default. In case of default, the asset will be taken by the bank. But the risk of default cannot be expressed by the accounting equation.
Consider you haven’t earned in meanwhile and you transfer 2Lakhs to loan account reduce the interest expenses which will be due next month. Then the equation will look like this
Assets (House: 30 Lakhs + Bank: 8 Lakhs) = Liability (Loan: 18 Lakhs) + Net Worth (20 Lakhs)
Now adding into this equation you get the salary of 10 Lakhs, Out of this interest comes to 1 Lakh and Loan Repayment of 9 Lakhs Happen. The EMI consists of both of these components. So the accounting equation after this will look like
Assets (House:30 Lakhs + Bank: 8 Lakhs) = Liability (Loan: 9 Lakhs) + Net Worth (29 Lakhs)
If you see the Net Worth figure it increased by 9 Lakhs. It happened because of Liability being reduced by 9 Lakhs. Since Income Increases assets value, income also increases the Net Worth. But Networth Increased by 9 Lakhs Whereas Income was 10 Lakhs. It was because of Interest Expense. Like Incomes increases an asset’s value, Expenses decrease it.
The Investing money to build a corpus
Normally the conversation about buying a house vs investing that money revolves around advantages of investing, the rate of return on House as asset etc… Since the folks cannot measure the effect of liabilities, it goes off track quickly. When a person invests money the money is moving from the bank account to the fund account. Hence this equation is nothing but movement within an asset. The accounting of it is like
Dr. Asset: Investments: Mutual Fund – ₹ 10 Lakhs
Cr. Asset: Current Asset: Bank Account – ₹ 10 Lakhs
The accounting equation after it
Assets (Bank: 10 Lakh + MF: 10 Lakh) = Liabilities (₹0) + Net Worth (20 Lakhs)
There is absolutely no change in Net Worth. In the case of Investing you make money only when the market moves. But unlike in the previous case, there is no charge on the asset. This gives peace of mind, as many want that.
- Investing does make money, the valuation change in invested corpus makes it.
- Buying a house makes money immediately because of Loan, but it increases the risk too.
- Liability to fund an asset always makes money at faster rates than plain investing, but the risk is higher too.