What are Liabilities?

What are Liabilities

Do you hate the word debt? Maybe you prefer liabilities. No matter which way you spin it, the definition remains the same. Debt or liabilities is money you owe to another person or a creditor. It’s money you have outstanding that you must pay back.

No matter what you call them, you should know what you have. Keep a tally as it affects your net worth and your overall financial health.

Examples of Liabilities

The sky is the limit regarding the type of liabilities you can carry. For example, if you borrow $100 from your parents, that’s a liability. You borrowed the money, and they expect it to be paid back. While you may not pay interest as you would at a bank, it’s still a ‘notch in your liability belt.’

Other more ‘formal’ liabilities may include things like credit card debt, a car loan, student loans, a mortgage, or a personal loan. You can borrow money from your local bank, a credit card company, an online bank, or even another peer (peer-to-peer lending).

Short-Term and Long-Term Liabilities

You may have short-term liabilities that you pay in a few years or less or long-term liabilities that last five years or longer. For example, a mortgage can have a term of up to 30 years. The longer you borrow the money, the more interest you pay both in the higher rate and throughout the loan since you pay interest on the outstanding balance.

Why Should you Care about your Liabilities?

Liabilities aren’t all bad. Most people have at least a few. But, having too many can create an issue and can show that you have poor financial habits. Keeping a close eye on how much you have outstanding at one time is essential to your financial wellbeing.

Before you incur a liability, ask yourself, is this going to increase your net worth?  For example, student loans, while a debt, may help you improve your net worth in the future. If you get a college education, chances are that you’ll get a better paying job than you would if you didn’t go.

If it’s not going to increase your net worth or provide some type of future value, then it’s not worth it. Racking up credit card debt typically isn’t a good liability. Unless you’re racking up the debt to build your business or do something else that may provide future income, it’s like a bad idea.

How Liabilities Affect your Net Worth

Your net worth is your assets minus your liabilities. If you were to sell every asset you had today, how much money would you hold in your hand?

In order to sell your assets, you’d have to satisfy your liabilities. For example, if you own a car, you’d have to pay off the car loan if you sold the car. The same is true of your house. If you sell your house, you’d have to pay off your mortgage.

Your net worth is your total assets minus your total liabilities. It’s your ‘profit’ after paying off your debts. Here’s an example (a simplified one):

You own the following:

–         House worth $200,000

–         Car worth $15,000

–         Bank account worth $50,000

You have the following liabilities:

–         Mortgage $100,000

–         Car loan $5,000

–         Credit cards $2,000

Your net worth is your total assets ($265,000) minus your total liabilities ($107,000) = $158,000

Your liabilities take away from your net worth. That’s why only taking out debt when it’s absolutely necessary is important. If you get careless and rack up credit card debt, it takes away from any assets you have, which decreases your net worth.

Bottom Line

If you do have liabilities, make sure you stay on top of them. Don’t pay them late or let them go unpaid. Bad credit habits damage your credit score. If you need a loan, to rent a house, or even to get a new job in the future, it may be difficult with a low credit score.

Your liabilities play an important role in your life. While too many liabilities are a bad thing, some are okay, especially those that increase your net worth over time. Give any liabilities you plan to take on serious thought before adding them. Is it worth it? Can you afford it? Will it add to your net worth? If you answer yes to all of these questions, then it may be worth it.

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