What are Liabilities?
In short, a liability is money you owe to someone else. It is your debt. This mostly consists of mortgage debt, credit card debt, student loans, personal loans, medical bills, auto loans. Liabilities can be used for good purposes, but it always subtracts from your net worth.
Used carefully you can leverage liabilities as a tool to increase your financial success. Used poorly you can completely wreck your finances and even end up bankrupt.
What are Good Liabilities?
You can argue that there is no such thing as good debt and you should only buy what you can pay cash for. I won’t go into that here, and it is generally true but not always reasonable in the real world. Generally speaking, good debts have the following characteristics:
- Used to buy an appreciating asset. If you took a mortgage out for a house or rental property it can generally be a good thing.
- The interest rate is low. It should be fairly close to inflation, typically under 5%.
- You used it to increase your earning power. This applies to student loans and small business loans.
- You can easily afford the payment. Even a good thing can be bad if you spend too much.
What About Bad Liabilities?
Bad debts are what you really have to watch out for. There is almost never a good reason to carry bad debt. You should really try and avoid it completely and if you have it you should strive to pay it off first.
Bad debt typically is unsecured, has high interest rates and is likely used to buy a depreciating asset. This means that you will generally owe more debt than you have assets to cover it. This is how your net worth goes negative!
Getting Out of Debt
If you find yourself in the situation of having too much debt, don’t despair! You can and should fix this. There are lots of methods to getting out of debt, but they all require some work and sacrifice from you.
One great way is the Dave Ramsey Debt Snowball Method. This method concentrates on paying off your debt from smallest balance to largest balance. This creates a snowball affect as you move through the debt, with accounts closing steadily to keep you motivated.
You could also try the avalanche method, which involved paying the debt off in order of interest rate from highest to lowest. This is more efficient, but may not give the satisfaction of closing accounts
Liabilities will decrease your net worth and should be use sparingly. Taking on a liability to buy a home is generally a good use of leverage, however it is rarely financially prudent to buy depreciating assets by taking on debt.
If you are in debt, there are multiple methods to get rid of it. Pick the one that you are most comfortable with and do it! Once the debt is gone your finances will be unchained and you can concentrate on building wealth.