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Knowing and understanding the difference between assets and liabilities is the key to financial wealth. Many of us may think that making more money from our jobs will eventually lead to wealth but that’s usually not the case unless we make millions from our jobs.
In order to DNA any kind of wealth, we need to have the key nucleobase: Assets – the A equivalent to Adenine in DNA.
We need to acquire more assets than we have liabilities. Not only that, but we must be able to tell whether something is truly an asset. There are some things that we think are assets but in reality, they are actually liabilities under certain circumstances.
For instance, did you know owning a home can be either an asset or a liability? It really depends on whether or not you live in it and how much it costs you to own, as well as the opportunity cost for owning the home.
Where we typically get into financial trouble is when we acquire liabilities that we think are assets. Acquire assets and you will create wealth. Acquire liabilities and you will fall into debt.
So, let’s understand the difference between assets and liabilities so we can start building wealth and live the dream life.
Difference between assets and liabilities
To simply put it, the difference, according to Robert Kiyosaki who is the author of the #1 personal finance book of all time, Rich Dad Poor Dad (affiliate link), is one that puts money in your pocket and the other takes money out of your pocket.
Can you guess which is which?
- Assets: Anything that puts money in your pocket, whether you work or not.
- Liabilities: Anything that takes money out of your pocket.
I really like how Robert made these terms so simple. Even though these definitions are not the official ones as defined in accounting and finances, they’re easy to understand. They make identifying what to get in order to create wealth from a financial standpoint.
If I were to ask you how you would describe an asset and a liability, what would you say? I know I would have said assets are things that I own that have monetary value, such as a car or a house.
However, when we use these simple definitions, we can see that a car and a home are both liabilities because they take money out of our pockets. For many of us, we finance both things – we have a car payment and a mortgage. Both also require money to maintain.
It may seem obvious that a car is a liability, but a home is one that causes the most confusion so let’s talk about that first.
A house is either an asset or a liability
Owning a house can either be an asset or a liability – it really depends on whether you are living in it (i.e. a home) or renting it for someone to live in (i.e. investment property).
Why a home is a liability
Buying a home (i.e. house to live in), like renting, is a liability because it takes money out of your pocket – you have to pay a mortgage and property taxes. This is not to say that renting is always better – which is better largely depends on your personal needs and what you do with the money you save.
And yes, like everyone says, owning a home is an investment. However, you are investing in a liability in exchange for things you cannot assign a monetary value to. Things like having privacy, flexibility, and convenience, which you may not be able to get when renting.
Sure, your home appreciates over time and you can likely sell it for more than what you bought it for.
But, the amount of money you would have paid in total interest, property taxes, renovations, among other things over the time of owning your home, in most cases, will exceed the “profit” you get when you sell. There is also potentially a huge opportunity cost such as missing out on other investments that may generate greater profits.
To give you an example, I will use my home and what it cost me to own it thus far. I will then compare that with what I can expect to get when I sell it. You can read about it here (coming soon).
Most people will tell you that your home is an asset. Even those who offer you loans will often see what assets you have and they will view your home as an asset. But when you think of assets and liabilities with these simple definitions, it’s easy to see that a home is a liability.
A house as a rental property is an asset
A house can be an asset, but only when it is rented to others.
This is because your tenants are paying your mortgage for you so your house is not taking any money out of your own pocket. Any maintenance or repairs needed for your rental property can be paid or covered in part with your monthly rental profits. Either way, you are not using your own money to cover the cost of owning the house whereas everything would come out of your pocket if the house was your home.
It is still an asset even if you live in it as long as you rent part of it and the rent is enough to cover the mortgage. This is in fact, the best scenario for saving money and owning a house “for free” but only if you are willing to share part of your home with people.
Credit cards are also either assets or liabilities
Credit cards can also be either assets or liabilities depending on how you use them.
When it comes to credit cards, many may think that they’re bad because there’s a lot of credit card debt in the United States. In fact, according to the recent data from the Federal Reserve Bank of New York released on February 11, 2020, credit card debt hit a record high of $930 billion.
That’s a lot of debt and a lot of people with credit card debt. It’s no wonder why so many people avoid using them.
But credit cards can be your assets because they reward you for using them and they put money in your pocket. You can get cash back for using credit cards and you can even get “free” travel and lodging.
However, credit cards can also be a liability if you are not careful in paying your balance off completely every month to avoid interest. Credit card interests are insanely high (as high as 25%), easily negating any reward you get and ruining your credit.
When used correctly, credit cards are assets. All it takes is to use them responsibly and treat them like your debit cards and how you normally would use cash.
Acquiring assets is key to financial wealth
One of the key nucleobases needed to DNA financial wealth is Assets. Buying or building assets and avoiding liabilities, especially liabilities that we think are assets, will eventually lead to financial wealth.
The ideal situation is one where we have many more assets than we do liabilities. The more assets we have, the more income we will have. Once the income from our assets can cover our expenses and liabilities, we will start to accumulate wealth.
To better understand this, let’s look at a diagram of the cash flow for the typical person and the ideal cash flow for creating wealth, as well as common examples of assets and liabilities.
Typical and ideal cash flow
Before we get into the cash flow diagram, here are a few definitions we need to know.
- Income Statement: Financial statement that measures your income and expenses – money in and money out. It is also often referred to as a Profit-and-Lost Statement.
- Balance Sheet: Financial statement that lists assets and liabilities at a specific point in time. Essentially this is a snapshot of your net worth. According to Robert Kiyosaki, it’s called a balance sheet because it’s supposed to balance assets against liabilities.
- Cash Flow: How your money is moved in (income) and out (expenses). The direction in which your cash moves show where your money is going and determines whether something is income, expense, asset, or liability.
Now that we know the definition for income statement, balance sheet and cash flow, let’s look at the typical and ideal cash flows. The diagram below shows the relationship and the cash flow pattern for someone who has only liabilities and someone who has both assets and liabilities.
Typical cash flow
The typical cash flow is one where our only source of income is our job.
As you can see, the money from our job goes directly towards paying our expenses, some of which are created by our liabilities. Money only goes in one direction – it comes in through your job and goes right out to paying expenses and liabilities.
Many of us try to ensure that our income is greater than our expenses by cutting costs and trying to save as much as we can. However, many of us also tend to acquire more liabilities over time.
Liabilities include mortgages, car loans, student loans, credit card debt, and other debt or loans.
With little to no assets to balance the liabilities, our expenses over time will eventually exceed our income, which is what ultimately leads to debt.
Ideal cash flow
The goal is to have an income that is greater than expenses and invest in acquiring assets and minimizing liabilities. As you can see from the ideal cash flow pattern, money still goes out paying expenses and liabilities. But, if you notice, there is what I call the H2O Money Cycle.
It’s like the water cycle, but with money. Imagine what would happen if water just went in one direction – it comes into the Earth and then goes out. We would eventually run out of water and not be able to survive.
The same is true with money. When we lose our jobs, our money runs out because that’s our only source of income.
The H2O Money Cycle continuously puts money into our pocket with assets. To create this cycle, the idea is to use our income to purchase assets that will generate money and put it back in our pocket. We then use this money to acquire more assets, which in turn will generate even more money, and the cycle repeats.
This is how we really start to get ahead financially. Our assets will supplement the income from our job and help pay expenses, including the ones created from our liabilities. Once we’ve acquired enough assets that can create more than enough money to cover all expenses, we would have created financial wealth.
Even without a job, our assets will be able to cover our expenses and more. Just imagine what it would feel like using all the money you earn from your job for all the things you love and anything you would like, and not having to pay a single bill or expense.
Assets include things like rental properties, stocks and bonds, IRAs, 401(K)s and credit cards, all of which are sources of additional income.
Related Article: H2O Money – The Water Cycle For Money
My past and current cash flow, assets, and liabilities
Back in 2015 when I started my first job, my asset column was completely empty and I had student loans under my liabilities. From then until the beginning of 2020, I had acquired only one asset, but I also acquired a few liabilities. My cash flow resembled a typical cash flow pattern.
The only two sources of income I had was my job and my 401(K), the latter of which is not liquid or usable. I also started investing in individual stocks in 2018 but I started at a bad time and I was a novice. By the end of 2018, I ended up losing over $1,000.
My dog is a financial liability
And YES, my dog Blue is a financial liability!
That’s not a typo.
Don’t get me wrong. She’s the cutest and sweetest dog ever and I love her to death. BUT, let’s be honest here… She takes money out of my pocket every single year. She requires food, treats, preventative medication, grooming, and toys. And OMG, don’t even get me started with the toys because all she does is rip them apart and destroy them!
But that’s OK. There is no amount of money that can ever make up for all the joy and happiness she brings to my life.
Anyway, back to talking about cash flows.
Everything started to change after I bought Ramit Sethi’s book, I Will Teach You To Be Rich (affiliate link). Through Ramit’s advice, I created my H2O Money Cycle and turned my cash flow into one that resembles more like the ideal cash flow.
In just one year I acquired a few assets and started to use the ones that I already had more often. I opened and used credit cards and online shopping portals for all my expenses where possible, which put money back into my pocket. I then used this money to fund my other assets to generate even more income.
And after letting my H2O Money Cycle work for one year, it made me over $30K in additional income outside my job in 2020. I was completely shocked at how well it worked in just one year.
Final thoughts
Knowing the difference between assets and liabilities is the first and most important step in starting our journey towards building financial wealth. The second step is to actually start building and acquiring them.
Making more money from our jobs can only take us so far. Our expenses, like taxes, tend to go up when we make more. We also have to work to earn money from our jobs and we can only work so many hours in a day.
Assets, on the other hand, will keep generating income for us regardless of whether we work or not. It’s OK if you currently do not have any assets or only have one. You can start to develop and acquire assets rather quickly and can even do it in just one year like I did.
It’s OK to have liabilities. We need to have certain liabilities in our lives. But we should focus on building our assets first before acquiring more and more liabilities. The sooner we start, the easier it is financially to take on new liabilities.
When you combine your assets with your income from your job and with a little time, you WILL start to create wealth.
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