How to differentiate between an asset and a liability? Most would say that asset is something of value that can be seen and felt. However, what you may be thinking is an asset may actually be a liability.
An asset is an object of value that provides you with a stream of revenue during its existence.
A liability is an object of value that has an expense or cost associated with it. When you decide to build your balance sheet in life, you need to be very clear with this definition as there might be certain confusions that you may encounter. The same item may be an asset in one condition and become a liability in another.
Your understanding can help you build more assets and hence help you build up more wealth. Here are a few points that would help you understand significance of understanding the difference in assets and liabilities in building wealth:
1. When you buy a house, is it an asset or liability?
Buying a house or a car
Buying a house is a high point in the life of most people and most people treat their house as the biggest asset
that they own. This only reflects on the lack of financial education of 90 percent of the world’s population that keeps them away from getting wealthy. You only need to ask yourself one question while deciding whether your house is an asset or not. If it helps you earn an income, it is an asset and if it only makes you incur an expense it is a liability.
Most people live in their own houses and pay mortgages to buy a house. Hence, it is clearly not an asset in this case, but a liability.
What is sad is that most people spend most of their savings in their house in which they live and think they have purchased an asset.
People who get rich invest only a part of their savings in the house they live in which is actually a liability. They spend more on buying other houses or properties from where they can enjoy rental income. In that case, house is an asset.
2. When you buy a car, is it an asset or liability?
The same goes for a car. If you are using a car for your personal use it is unlikely you will be earning anything from it. You only spend on its upkeep and mortgage. Hence, it is a liability for most people. Most middle class people like to buy first hand cars to flaunt their style. The wealthy people understand that the car is a liability and generally pick up the pre owned versions of the cars to minimize their cost.
3. How to build assets
If you wish to be rich it is important to build more and more assets and minimize your spend on liabilities. So make a clear distinction on what you are planning to purchase by calculating the net inflow
and outflow from that purchase. If you are earning from that purchase you are building an asset, and if you are in a loss, you are buying a liability.
It is clear that you need to work towards building assets in your life if you want to generate wealth for yourself. Building assets may take some time, but these assets once build can feed you and your family for many generations to come!