Assets Versus Liabilities

by James on 02/18/2010

Image of the assets we would like to have. Cash.

Okay, I know, I know. You already know what assets and liabilities are. You learned this in your accounting 101 class. Assets are good and liabilities are bad. Right? Seems pretty simple, but why is it that so many people have different opinions on whether certain items are assets or liabilities? Or, whether all assets are good and all liabilities are bad? For instance, is your house an asset? Is all debt harmful to your health? Let’s tackle these questions one at a time.

What is an asset?

Wikipedia states that assets are things of value that can be readily converted into cash (although cash itself is also considered an asset).

What is a liability (debt)?

Wiktionary states that a liability is an obligation, debt or responsibility owed to someone.

What do you think about these definitions? Do they sound about right? Sure they do. However, these definitions will almost certainly keep you from achieving financial freedom, especially if you are pouring a lot of your extra, hard earned income into your personal residence and trying to avoid all debt like the plague. And, this is where most people get confused. Lets clear up the confusion.

Is your house an asset?

Yes, your house is an asset. Whew! You were starting to get worried there, right? But wait a second… your house is NOT really your asset (unless you have paid it off). It is the bank’s asset. The bank owns your house if you have a mortgage on it. Therefore, your house is a liability to you. What?! Why? Because you make a mortgage payment for it every month and on top of that, your house creates additional liabilities for you each month! Energy bills, telephone bills, cable bills, Internet bills, water bills, association dues, etc. What about maintenance costs? How about a new roof? Broken appliances? Plumbing issues? The list could seem endless. And, who gets to keep your house if you can’t pay your taxes? Or, if you can’t make a mortgage payment? What happens if a hurricane comes to town, destroys your house and your insurance company decides not to pay to rebuild it? Do you get my point?

Simply put, to reach our goal of financial freedom, we need to invest our earned income into assets that will make us more money, passively. The argument can be made all day about how much equity you have built into your home with appreciation and home improvement, and that is wonderful, but this will not get you, me or anyone else any closer to financial freedom. The key to financial freedom is having passive income streams that exceed your expenses. Invest your money into assets that will generate you passive income and you will be one step closer to the life you have been dreaming of.

Are all liabilities detrimental to our financial well-being?

Absolutely not! But, please don’t go out now and rack up a bunch of debt on your credit cards! This is most definitely bad debt. So what constitutes as good debt? You have good debt when you owe money, but someone else pays it off for you. How in the world can we convince someone to pay off our debts? Many ways! If you have a business, many times you need to invest in equipment. Your customers pay you and their money pays off your equipment. Another example is if you have a rental property. The tenant pays you and their rent check pays off your mortgage. So by taking out a loan (liability) you are leveraging other people’s money to make money for yourself. Sounds pretty good, doesn’t it?

Well, I sure hope this has helped clear up the confusion about assets and liabilities. I don’t want anyone to think that I believe that purchasing a home is a bad decision. That is not what I am saying at all. I am living in a house and I have a mortgage payment. What I am saying is that you should live within your means so that you have extra money left after you pay all of your bills each month. Use this leftover money to buy passive income producing assets.

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