Liabilities are the opposite of assets. They are things that are negative to your portfolio.
So what is something that is not good for your portfolio? In a word: debt. Liabilities are money you owe, things with interest rates working against you, and things that require money to be functional.
Money you owe is a liability because it is a known sum of your assets that belongs to another entity (which can be a person or business).
Money you owe with no interest is one of the least threatening liabilities. The reason is because the amount you owe is affected by inflation over time. The longer you wait to pay the sum, the more the sum will lose its purchasing power for the lender. Therefore, you can technically earn more by waiting to pay the sum off as long as possible and investing in assets with higher returns.
The loss of value due to inflation and the risk of never getting paid back is the reason most lenders ask for interest. A loan is an asset to the lender. Therefore, it is in the lender’s best interest to ensure that asset is at least meeting the rate of inflation.
Money you owe with interest is more threatening, especially when the interest rate exceeds inflation. In addition to battling inflation, you must now account for the additional loan interest that is consuming your profits from other investments and/or negating the future purchasing power of your current assets prematurely.
Let’s put some numbers to this theory. Consider three loans, each with a principle (the amount of money you start with) of $10,000 and no minimum payments. The first is a loan from your family at 0.0% interest APY. The second is a mortgage at 2.5% APY. The third is a student loan at 5.0% APY. How much would you owe at the end of ten years if you didn’t put anything towards any of the loans?
I have also added a column to illustrate how much money you would need to equal the purchasing power of the $10,000, from when you first acquired the loans, assuming 3.0% inflation every year.
Note, if the interest rate is less than inflation, the lender incurs a loss. If the interest rate equals inflation, the lender would break even. Once the interest rate exceeds inflation, the lender makes a profit.
Liabilities are also things that require money to function or be useful to you. Remember the ven diagram from the explanation of assets? There is a fourth circle that needs to be included. Instead of possessions being non-liquid assets, some people consider certain possessions to be liabilities.
For example, a car requires money to be operational. You need to pay for gas, maintenance, and insurance. Even if you sell the car for money at the end of the useful life, you still spent thousands to buy, use, and maintain it.
The same could be said for a house. You could buy a turn-key residence, but you will still need to pay for maintenance, property tax, and insurance. In addition, you are also paying interest on a mortgage payment.
These examples do not even account for the value of the time and effort you put into these “assets.”
An example of a persons assets and liabilities categorized using the ven diagram method, would look like the diagram below.
To strengthen your portfolio, you should avoid liabilities. You can’t avoid them entirely, but you can limit your exposure to them as much as possible. Avoid loans. Only buy what you can afford with the money you have now. You need a place to live, so buy or rent a reasonable place that you can afford and use efficiently. You need a mode of transportation, so consider walking, biking, or using public transportation.
Every dollar you spend rather than invest is money that is earning you zero or negative future purchasing power. Consider your purchases wisely.
Now that you know what liabilities are, figure out what kind you have and update your ven diagram. How does your diagram look? Are you happy with how it looks? Let me know in the comments!
Next time, we will discuss net worth.