Understanding the 4 sides of Finance

There are 4 components of finances:  assets, liabilities, income and expenses.  Everything in your financial world falls under these 4 categories.  Each of these categories is further divided into accounts – each of which is just a way of tracking certain activities.  For example, a ‘checking account’ is just an asset stored at the bank and a log of the deposits and withdrawals out of that asset.

Assets are things of value that you own.  Things such as your house, a portfolio of stocks, a mortgage that you collect on, an IRA account are all assets.  The value on your assets may rise or fall, but they are still assets.  The best kind of assets is income-producing assets since these assets produce a regular income for you.

Liabilities are debts.  Usually these are the result of somebody else giving you one of their assets with the expectation that you will give it back to them.  For example, a mortgage that you pay on (your liability) was money that the lender had (their asset) and they gave it to you so that you could buy your house (your asset).  The lender wants their asset back and they want some interest (their income, your expense) along with it

Income is value derived from something that you did (wages) or from one of your assets (rent or interest).  Most income is in the form of money, but it could be in the form of credit.  Credit is really an asset, so this kind of income came as an ‘idea of money’ that you deposited into an asset account.

Expenses are value that you expend.  This value is usually in the form of money and comes from either an income account, an asset account or it adds to a liability account.

Imagine that you are standing in a room with 4 walls – each wall is full of little mailboxes.  Each wall represents one of the 4 components and each mailbox is an account.  When you open the mailbox called ‘wage’ on the Income wall and pull out your gross pay, you need to put some of the money into a mailbox called ‘Taxes’ on the Expense wall and the rest can go into a mailbox called ‘Checking Account’ on the Asset wall.  Each check you write is pulling money out of the ‘Checking Account’ mailbox on the Asset wall and putting the money into some other mailbox on one of the 4 walls.  I originally heard this metaphor from Mike Butler (www.MikeButlerSuccess.com)

Common mailboxes:

• Mortgage You Pay On has a mailbox called ‘mortgage’ on the Liabilities wall (with the principal balance) and a mailbox called ‘mortgage interest’ on the Expense wall.  You may also have a mailbox called ‘insurance & tax escrow’ on the Assets wall to track money that is held by your lender to pay insurance premiums (expense) and property tax (expense)
• House That You Rent To Others has a mailbox called ‘Rental House’ on the Assets wall.  There is a mailbox called ‘rental income’ on the Income wall.  There may be a set of mailboxes for the mortgage (as described above).  There is also a set of mailboxes for the different kinds of landlord costs on the Expense wall.