Knowing the difference between assets and liabilities is the first and most important lesson towards gaining financial consciousness.
Whole of our life we go by the populist classifications of what’s an asset and liability, but from ages ‘riches’ have defined it differently and that’s what has made all the difference between them and us.
Accounts define assets as things we own (cash, house, car, etc.), and liabilities as things we owe (our obligations, like mortgages, dues, etc.). Old wisdom is in consonance with this idea. Earlier people believed that owning a house is life’s biggest asset, and what’s better if you own a car; it’s like an icing on the cake. But it’s important to understand that old rules have limitations and applying them blindly will only screw our finances.
What turns money into more money
The difference between rich peoples’ approach towards assets and liabilities and ours is – rich people consider those things as assets which turn their money into more money on a regular basis, and we, by old populist definitions, consider those things as assets for which we wait for half our lifetimes to give us monetary benefits.
A house might be an asset for my grandfather or the accountant whose aim is to make the balance sheet look good, but for the riches and our immediate present, it’s actually a liability.
So, what are the new rules of the game? How does rich define assets and liabilities? Where is the middle class going wrong?
In the pocket and out of it
Simply put, an asset is something which puts money ‘in the pocket’ and a liability takes money ‘out of the pocket’.
Let’s take house as the example. Traditionally, it’s considered as one of the biggest asset. But is it?
The house is not an asset because it ‘eats money’- via EMIs, maintenance, taxes, etc. It takes money ‘out of pocket’. It’s not an asset until it’s sold, and even then, when you finally sell it, it will cease to become an asset you ‘own’. That’s why house is a liability, UNLESS…
Yes, the house is going to remain a liability unless it generates regular income. If you put the house on rent and generate enough amounts such that it not only cancels your expenses, but earns you extra income, then it can be considered as an asset.
Paying for living with the society
Make your rental income cover your EMIs, maintenance, taxes, etc., if you truly want to make your house an asset. Until then, it’s only going to remain a liability, which is sort of a ‘cost that you are paying for living with the society’.
So, real estate will be an asset only when it generates regular income. Similarly, cash is no asset in itself, unless it’s invested in stocks, bonds, mutual funds, and other investment modes which bring in regular capital gains.
LESSON: Owning ‘things’ does not create assets. Fundamentally, a true asset must create more wealth. Assets not only retain earlier capital, but also generate extra income from profits. An asset is what ‘brings money in’ the pocket and a liability takes it away from the pocket.
