We’ve looked at what you own. Now let’s look at what you owe. Liabilities are the other side of the net worth equation. And for most people, they’re the side that hurts.
What is a liability?
A liability is any financial obligation you have to someone else. It’s money you owe, usually with interest. Every liability reduces your net worth by its full amount.
Common liabilities:
- Mortgage: the loan on your home
- Student loans: money borrowed for education
- Car loan: financing for a vehicle
- Credit card balances: revolving debt, often at high interest
- Personal loans: borrowed money from banks or individuals
Why the interest rate matters more than the balance?
Not all liabilities are equally dangerous. The interest rate determines how expensive a debt is over time.
A mortgage at 3.5% on €200,000 costs roughly €100,000 in interest over 25 years. That’s significant, but the home may appreciate and you’re building equity.
A credit card at 22% on a €3,000 balance, if you only make minimum payments, can cost more than the original amount in interest alone. You pay for your purchases twice: once at the register, once to the bank.
The same concept: borrowing money but with wildly different outcomes. The interest rate is the difference.
A framework for evaluating debt
Instead of “good debt” and “bad debt”, which oversimplifies things, ask three questions:
- What is the interest rate? Compare it with inflation and with what your investments could realistically earn after tax. In low-inflation countries, rates above roughly 8-10% are usually expensive and worth addressing quickly; where inflation runs higher, the line sits higher too
- What did the debt buy? Debt that funds something appreciating (education, a home) has a different character than debt that funded consumption (a holiday, a dinner)
- Can you comfortably make the payments? Even low-interest debt becomes a problem if it eats too much of your cash flow
The main types of debt
Mortgage debt is usually the cheapest interest rate you’ll find. It buys an asset that may appreciate. In some countries, mortgage interest is tax-deductible, though this benefit is being phased out or restricted across much of Europe. Whether any relief applies is set by national tax law. The catch: it’s a long commitment and you need stable income.
Student loan debt invests in your earning potential. It makes sense if the education leads to a career that meaningfully increases your income. It doesn’t make sense if the degree costs more than the salary increase it delivers.
Credit card debt is the most common trap. High interest, compounding daily, easy to accumulate and hard to eliminate. If you carry a balance, every purchase effectively costs more than the price tag.
Consumer loans for depreciating assets, for example, financing a car or furniture at high rates means you’re paying interest on something that loses value from the day you buy it.
The rule of thumb
A widely used rule of thumb: when the interest rate on a debt is higher than the after-tax return you could reasonably expect from investing, paying the debt down usually comes out ahead. The logic is that paying off debt is a guaranteed return equal to its rate. No reliable investment pays 20% guaranteed, and a credit card charging that is hard to beat. The rule gets fuzzier in the middle: a 5% loan against an uncertain investment return is a judgement call that depends on tax, inflation, how much cash you have in reserve and how much certainty you want.
What this means for your net worth
Every liability subtracts from your net worth. But the way debts are handled makes a huge difference:
- High-interest debt is the clearest case for fast repayment, because clearing it is a high, guaranteed return
- Low-interest debt is where people differ: some prefer to invest the difference for a higher expected return, others prefer the certainty of being debt-free
- Missing minimum payments is costly almost everywhere: lenders add fees and penalties, and it damages your credit record
In the next post, we’ll look at two well-known strategies for paying off debt, and what each one suits.