Liability is a fancy word for debt, or something that you owe. Once you know your total liabilities, you can subtract them from your total assets, or the value of the things you own — such as your home or car — to calculate your net worth.
Liabilities are a part of your overall financial health, but they are not all harmful as long as you keep them in check.
What is a liability?
A liability is money you owe to another person or institution. Liabilities lower your net worth because you're obligated to repay them.
What are some examples of liabilities?
A liability might be short term, such as a credit card balance, or long term, such as a mortgage. All of your liabilities should factor into your net worth calculation. Examples include:
- Auto loans.
- Student loans.
- Credit card balances, if not paid in full each month.
- Mortgages.
- Secured personal loans.
- Unsecured personal loans.
- Payday loans.
- Buy now, pay later loans.
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Why do liabilities matter in personal finance?
Liabilities reveal a lot about your relationship with money and credit, but you’ll need to put them in context. The type of debt you incur is key to understanding whether your liabilities might help you build wealth or hold you back.
How liabilities can help build wealth
Certain liabilities can help increase your net worth over time. For example, student loans finance your education and might lead to a higher paying job. Other liabilities, such as credit card debt, aren’t going to add to your net worth.
» RELATED: Learn what it means to be a high net worth individual.
How liabilities can hurt your finances
Liabilities can become problematic if they significantly exceed your assets, leaving you with a negative net worth. Liabilities could also interfere with your ability to pursue financial goals, such as building an emergency fund or saving for retirement.
Think of it this way: Every dollar that goes toward a loan balance or interest payment is one less dollar you have to save, invest or put toward your expenses.
How can you reduce your liabilities?
No matter how much debt you have or what kind, have a plan in place to pay it down — the sooner, the better. Typically, the more time you have to build up your assets, the less weight your liabilities will carry.
If you’re unhappy with your net worth number and think your liabilities are to blame, take steps to pay off debt efficiently. You could try the debt avalanche method to wipe out your highest-interest debts first. Or, you could try the debt snowball method, which prioritizes paying off your debts from the smallest to the largest.
You might also think about finding ways to make more money, such as getting a side gig or asking your boss for a raise.
If managing your liabilities seems overwhelming, consider working with a credit counseling agency to create a debt relief plan.
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