If you've heard anyone talk more than 10 minutes about wealth, you've likely heard of assets and liabilities. Just like folks from New York can't wait to tell you that they're from New York, finance folks can't wait to bring those terms up. Even if you didn't hear those words specifically, you probably heard an asset or liability mentioned.
Assets and liabilities are what make up your net worth. All you do is subtract your liabilities from your assets and voilà.
Defining an Asset
An asset is anything that you own that has monetary value, including the cash in your checking and savings account. Assets are divided into two groups: tangible and intangible.
Tangible assets are things you own that can be physically touched. This includes your crib, car, jewelry, furniture, electronics, collectibles, etc. If you can see, feel, or hear it, it's tangible.
Intangible assets would be things that have value, but you don't physically possess—like money in bank accounts, stocks, bonds, retirement accounts, cryptocurrency, and other investments.
Defining a Liability
A liability is a debt or obligation you owe to someone else, including the loans you take out to purchase a new crib or car, and any credit card debt you have. What's a liability to you is generally an asset to someone else. As a rule of thumb, if it shows up on your credit report as something you owe, it's a liability. Even if you plan on eurostepping your student loans until one of these Presidents eliminates them for good, you have to include them when calculating your liabilities.
Like assets, liabilities are divided into two categories: current and non-current. Current liabilities are debts that need to be paid back within one year, like short-term loans, payday loans, credit card payments, and taxes owed. Non-current, or long-term, liabilities are liabilities that will need to be paid in over a year, like mortgages, car loans, and student loans.
Your debt ratio is the amount of liabilities you have compared to your assets. If you owe everybody and their mama with little assets to your name, your debt ratio is likely higher than California gas prices. For example, if you own $50,000 in assets but have $25,000 in debt, your debt ratio would be 50%. Ideally, you want to keep your debt ratio below 40%. The lower the percentage, the better, and anything over 60% is considered bad.
Why it Matters
The amount and type of debt someone has gives insight into their financial health. Some liabilities, like student loans and mortgages, are liabilities that will eventually become assets—whether from a higher paying job or owning a house—so they're not necessarily "bad," but they're liabilities nonetheless.
The real problem is when your liabilities start to largely outweigh your assets. Having all those debt obligations make it hard to use that money in more productive ways, such as buying more assets. Or, ya know...just living life and not feeling like your paycheck belongs to everybody but you. Not only do you suffer at the time by having to make those debt payments, but you also slow yourself down from flourishing in the future.
Imagine if you repay $1,000 in debt each month. Over five years, that's $60,000 in debt payments. If you invest that same $1,000 in the stock market (which historically averages a 10% return annually) each month, you'll accumulate over $80,500. Hell, even if you invest half of that each month, you'd still accumulate over $40,200.
Banks and other lenders consider people with high debt ratios risky, so you should have an idea of what yours is before going to apply for lines of credit. If you know you want to make a big purchase soon that will require financing, start planning to lower your debt ratio before applying for the loan.