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Article

Valuing Liabilities like Assets

It’s natural for you to gravitate towards the idea of financial planning being focused on growing assets such as stocks, bonds and real estate. Many are surprised to learn that developing a comprehensive financial strategy doesn’t only involve focusing on what you own, but also what you owe.

September 10, 2024
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When the topic of financial planning comes up, most individuals naturally gravitate towards the idea of growing their assets. Stocks, bonds, real estate, and retirement accounts usually dominate these discussions. However, a comprehensive financial strategy doesn't only involve focusing on what you own, but also on what you owe. Liabilities, or the debts one owes, are just as crucial to understand and manage, especially in an economic environment of rising interest rates.

Why Liabilities Matter

  1. Net Worth Calculation: At its core, a person's net worth is calculated as assets minus liabilities. If we only focus on half the equation, we can get a distorted picture of financial health. A person might own assets worth a million dollars but could be deep in debt, resulting in a low or even negative net worth.
  2. Cash Flow Implications: Monthly debt payments can take up a significant portion of an individual's income.

    This can restrict the ability to invest for the future, save, or even cover daily living expenses. Understanding and managing liabilities helps ensure a smoother cash flow.
  3. Interest Rate Risk: With floating rate debt, the interest rate isn't fixed but varies based on market conditions. In a scenario of rising interest rates, the cost of servicing this debt can shoot up rapidly, making it more expensive for the borrower.

Treating Liabilities Like Assets

Given the importance of liabilities, here's how one can give them the same attention as assets:

  1. Regular Review: Just as one would review an investment portfolio periodically, it's essential to review outstanding debts. This includes checking for interest rates, payment terms, and the remaining balance.
  2. Refinancing Opportunities: As markets evolve, there might be chances to refinance debts at a lower interest rate or better terms. This can result in significant savings over time.
  3. Prioritizing Repayment: Not all debts are created equal. Some might have a higher interest rate, while others might be tax-deductible. By understanding the nature and cost of each liability, one can create a repayment strategy that maximizes financial benefits.
  4. Establishing an Emergency Fund: One of the best ways to prevent unnecessary debt is by having an emergency fund. This cash reserve can cover unexpected expenses, reducing the need to rely on high-interest credit options.
  5. Considering Debt in Investment Strategy: If an investment opportunity offers a return of 6%, but one has outstanding debt with an interest rate of 8%, it might make more financial sense to pay off the debt first rather than invest. It's essential to weigh the prospective returns against the guaranteed cost of the debt.

A holistic financial plan is a two-sided coin: assets on one side and liabilities on the other. By valuing liabilities in the same way we value assets, we not only get a clearer picture of our financial health but also make informed decisions that set the stage for long-term financial stability and growth. As interest rates evolve and economic conditions shift, understanding and actively managing liabilities becomes not just a good practice, but a necessity.

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