Difference Between Debt & Liabilities

Difference Between Debt & Liabilities
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At first glance, “debt” and “liabilities” may appear to be synonyms for the same concept. But there actually is a difference. Debt specifically refers to money you borrow, but liabilities cut a wider swath to include all your financial obligations. In this context, debt represents one type of liability, but it also means that not all liabilities are considered debt.

What is Debt?

Whether a debtor is an individual or a large corporation, debt represents the amount of money one party borrows from another. The terms of debt payback vary among lenders, but most debt arrangements include interest – the amount that a lender charges for the borrower’s privilege of borrowing money, which is commonly expressed as a percentage of the original loan amount.

Interest may be "simple" (a set percentage based on the principal amount of the loan) or "compound" (computed on both the principal and any accrued interest). Debt allows a payment arrangement for a sum of money that borrowers may not have on hand; for example, to make purchases that the borrowers could not otherwise afford.

Examples of Personal Debts

For most people, common types of debt include mortgages, personal loans and credit card debt. Although mortgages and personal loans generally have a fixed term, at the end of which the loan is satisfied (installment debt), credit cards may have rolling or open-ended repayment terms (revolving debt). Individuals may also have student loan debt, which is money that's borrowed to pay for education costs.

With “money that you borrow” as the definition of debt, individuals still have other types of expenses that don’t fit the debt definition. Although some people may refer to their monthly bills as debt, these expenses are not typically included when, for example, lenders calculate someone’s debt-to-income (DTI) ratio for qualifying to receive a loan. Monthly expenses such as utility bills, phone bills and even television service bills aren’t debts, because they do not represent borrowed money.

How Debt Affects Your Credit Score

If you’re applying for a mortgage, a consumer loan, a credit card or other type of financing, the lender may calculate your debt-to-income (DTI) ratio as one indicator of your creditworthiness. Even though all debts used to calculate DTI aren’t on equal footing, which means the DTI results can be slightly skewed, this metric is still an important contributor to the overall lending process. For example, the repayment terms of a credit card certainly include a higher interest rate and rate of servicing than a student loan, but for purposes of calculating DTI, both debts are included equally in the equation.

Although the thought of having debt may leave you a bit unsettled, it's possible to use debt as a credit tool that works to your advantage. If you populate your credit report with a good repayment history of your debts, lenders will favorably look at you as a person who has been responsible with borrowed money. As a comparison, the person with no debt repayment history is a "wild card" in lenders' eyes. Even though that person may be extremely responsible with her financial obligations, a lender has nothing on paper to confirm this.

Examples of Business Debts

There’s an overlap of certain debts that individuals and businesses may have in common, such as mortgages and automobile loans, but businesses may also have certain types of corporate debt that individuals don’t have. The classic example is bonds, which actually represent loans that consumers make when they purchase bonds from a company. The company (the issuer of bonds) effectively borrows money from the individuals who purchase the bonds. Since the company is borrowing money (and paying interest to the bond investors), the bonds it issues become a business debt.

What is Liability?

In the world of business, if you think that liabilities are debts owed by the business entity, you're on the right track but with a simple reversal of the two terms needed to hone this financial concept. Debts are one type of liability, but not all liabilities are debts. More specifically, the difference between debt and liabilities is that debt refers to borrowed money, but liabilities can also include other types of financial obligations. For example, accrued wages and income tax are liabilities, but they are not debts because they do not represent borrowed money.

Another difference between debt and liabilities is that a liability doesn’t have to be monetary in nature. A liability can also be goods or services that a company owes to someone or to another company. These obligations of liability also carry future value – transactions that are not settled yet but will be at a later date.

Difference Between Liabilities and Expenses

A company's expenses represent the cost of doing business -- the cost of its operations that generate revenue. Expenses are tied to revenue, and they're used to calculate a company's net income. But liabilities represent the company's financial obligations, including the debts it owes.

Categories of Liabilities

Broadly defined, liabilities can be separated into three categories – short-term liabilities (also called current liabilities), long-term liabilities (also called non-current liabilities) and contingent liabilities.

Although the word “current” may sound like a right-now scenario, it actually means that they’re payable within 12 months.

Long-term liabilities are those that will be resolved in more than 12 months. In the case of some long-term liabilities, such as a mortgage, the liability stays on a company’s books for many years, but the payments on a mortgage that are due in a current year are categorized as the current portion of the long-term liability.

Contingent liabilities are only potential liabilities, because they depend on possible outcomes from future events.

Examples of Liabilities

Current liabilities include:

  • Wages payable
  • Bills payable
  • Dividends payable
  • Short-term loans
  • Accounts payable
  • Interest payable
  • Income taxes payable

Non-current liabilities include:

  • Mortgage payable
  • Bonds payable
  • Long-term notes payable
  • Deferred tax liabilities
  • Capital lease

Contingent liabilities include:

  • Lawsuits
  • Product warranties

Relationship Between Assets and Liabilities

Whereas a company's liability represents its total financial obligation, including its debts, its assets represent its ownership. The things a company owns may be tangible, such as buildings and equipment, or intangible, such as accounts receivable and patents.

By subtracting its liabilities from its assets, a company determines its owner's equity (also called stockholders' equity).

Other Definitions of Liability

There's another type of financial liability that may ring a bell with you. Your tax liability is the amount you owe to a city, for example, to pay property tax on your home or vehicle. Another type of tax liability is the one you have for paying your state or federal income taxes.

You may also have another type of liability -- a legal liability -- if someone sues you as an individual or if someone sues your company. Liability insurance is structured around the possibility that someone may sue a business for negligence.