What is a Liability
A liability is something that you owe to someone else. In essence, a liability is a debt. Your net worth is the sum of your total assets minus your total liabilities. An example of a liability is the balance owed on your credit card.
Detailed Look at Liabilities in Personal Finance
Liabilities can be short-term, such as your credit card debt, or long-term, such as your mortgage. You gain a liability when you owe money to someone. For example, if you purchase a car and take out a $20,000 auto loan, you gain a $20,000 liability to the bank that loaned you the money.
A short-term liability represents liabilities that you can pay off in 12 months or less. Credit card debt is generally considered a short-term liability as many people intend to pay off their current credit card debt within a year.
A long-term liability represents liabilities that take greater than 12 months to pay off. Auto loans and mortgages are examples of long-term liabilities.
It's normal to have liabilities throughout your life, but when you have too many liabilities compared to your total assets, that's when you can have issues. Having more liabilities than assets means you have a negative net worth.
Liabilities Versus Assets
A liability is something you owe to someone else, whereas an asset is something you own. Therefore, you subtract liabilities from your net worth. In contrast, you add assets to your net worth.
Examples of Liabilities
As liabilities are anything that you owe to someone else, here are some examples:
- Credit card debt that isn't paid in full at the end of the month
- Auto loans
- Personal loans
- Student loans
- Money owed to friends or family
- Medical debt
- Payday loans
- Debt in collections
When calculating your net worth, it's important to consider all of your liabilities as well as all of your assets.
Why Liabilities Matter
Your liabilities affect your net worth and give you an idea of your financial health. When you determine the amount of liabilities you have in comparison to your assets, you can better understand how you are with money.
Not all liabilities are bad. For example, a liability that helps you make more money later in life would be beneficial to incur. If you were starting a business and took out a business loan to get started, your business loan is a liability, however, the loan exists to build a successful business which will make you a lot more money.
Having too many liabilities can cause financial issues as you may have trouble reaching your financial goals if you owe a lot of money. This is why it makes sense in most cases to pay down your debts as soon as possible.
How to Reduce Liabilities
To reduce your liabilities, come up with a financial plan. This can include cutting back on spending so to have money to apply towards debt balances.
Another way to have extra money to pay down debt is to make more money via a side hustle or working overtime, if possible. Doing either of these can be temporary if only to pay down your debt quicker, or you can do them permanently to reach financial goals more rapidly.
Choosing a place to focus is a good start, such as focusing on your credit card debt, as this type of debt often has the highest interest rates, which costs you the most amount of money over time.
How Do I Know If Something Is A Liability
A liability is something you owe to someone else. If you have to pay someone or an entity, like a bank, money for something, then that is a liability.