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The basics of assets and liabilities are straightforward, and the definitions are very basic. Yet understanding assets and liabilities and how they impact your financial circumstances can be the difference between financial success or failure.
In accounting terms an asset is something you own, that provides a future economic benefit. It is an item that can be sold and has intrinsic value. A liability is money you owe or debt you hold.
Assets include cash, investments, bank accounts, real estate, vehicles, collectibles, antiques and other items you own.
Liabilities include mortgages, home equity loans, automobile loans, student loans and credit card debt.
As an individual or a business the goal is to have a positive net worth, and to have that net worth grow over time. Net worth is established by adding your assets and subtracting your liabilities. If the number is positive there is a positive net worth. This number establishes your financial value.
There is more to assets and liabilities than a definition and numerical calculation determining financial value. The better assets and liabilities are understood the better financial decisions can be made. This is what builds wealth.
Not all assets are equal because assets are either gaining or losing value. Assets that gain value are appreciating assets and assets that lose value are depreciating assets.
Appreciating Assets increase in value over time. These are investments. When we put money in a savings account, certificate of deposit, bond, or mutual fund we are anticipating that the asset (account) value will increase. Purchasing a home creates the expectation that the asset will grow in value during the period of ownership.
Depreciating assets include purchases that lose value over time. Let’s say you buy a new outfit. Whether it is a simple outfit or a fancy suit or dress does not matter. Whether you paid $100 for it or $1000 for it, the results are the same, you will never be able to sell the outfit for what you paid for it. This is a depreciating asset. Unfortunately much of the money spent falls into this category. The cars you drive, the food you buy, and trips you take are all depreciating assets. Once the money is spent on the item, you may be able to use it, but you will not get the value from the item, that went into the purchase.
Debt creates a liability. This is true even for assets like real estate. The challenge with debt is that the interest that is paid, reduces the equity in the asset. If you buy a home and pay $200,000, but then over the course of the mortgage pay another $200,000 in interest, the actual costs of the home is $400,000 plus repairs and improvements that were put into the home. If you do not make purchases wisely all of the equity (assets minus the liability) can be lost in interest payments.
When looking at assets and liabilities as to tool to increase wealth, it becomes possible to make better financial decisions that will build your portfolio. Then, financial goals can be reached and your net worth increased.