What is Net Worth?
The formal definition of net worth is the combined value of everythingn you own (Assets) minus the value of everything you owe (Liabilities). In other words, if you total up your financial life: sell everything that you own and pay off all of your debts, what do you have left over?
Net Worth = Assets - Liabilities
What I love about net worth is how easy it is to understand and how easy it is to calculate.
Assets are things that you own that have monetary value such as: cash, checking/savings accounts, retirement accounts, houses, cars, personal property, etc.
Liabilities are cash (or value) that you owe to other people or institutions such as: mortgage balance, student loans, car loans, credit card loans or personal loans.
What does Net Worth really tell you?
If you have a positive net worth, that means that you own more stuff than you owe and that's great! A negative net worth on the other hands means that you owe more than you have. This is typical when you are young and starting out: you might borrow aggressively in order to fund your future growth. Things like an education (student loans) and a mortgage (to buy a home) might lead to larger debt than you have assets.
When calculating Net Worth periodically (quarterly or yearly), it can be viewed as a financial report card that allows you to easily evaluate your financial health at a glance. Is it moving in the correct direction (more positively)? And if not, what are the causes?
Like the stock market, your net worth will fluctuate. However, also like the stock market, it is the overall trend that is important. Ideally, your net worth continues to grow as you age: as you pay down debt, build equity in your home, acquire more assets, and so forth. At some point, it is normal for your net worth to fall, as you begin to tap into your savings and investments for retirement income.
Why is Net Worth Important?
A few reasons that I like tracking Net Worth include:
- Track your financial progress. It's quick and easy to calculate your Net Worth each quarter or year. This allows you to measure your progress over time and compare it to previous time periods. You want to see a growing net worth; a decline in net worth means you have more work to do.
- Look beyond Income. How to grow your income is often a financial focus. But honestly that's really less than half the equation. The important parts are: how much are you saving (adding to net worth), how much are you investing responsibly (growing net worth) and how much are paying off debt (reducing liabilites = adding to net worth). Even if your income is growing, if your net worth is flat or declining, your financial situation may not be improving at all.
- Avoid focus on Asset Value. Many people focus on the value of their assets as a measure of their personal financial health. But if you take on a lot of debt to fund many purchases, you're no better off. Look beyond the positives of assets (the fun stuff!) and make sure to include all of your debts. The good news is that for many debts, the balances are shrinking with those monthly payments and therefore you get positivie reinforcement when including debts along with assets (valuing both equally).
- Keeps debt level in perspective. It's natural to get overwhelmed with large debt obligations like a mortgage. But knowing that you have an evern larger asset offsetting that debt can help keep things in perspective.
When you see financial trends in black and white on your net worth statements, you are forced to confront the realities of where you stand financially. Reviewing your net worth statements over time can help you determine where you are, and how to get where you want to be. This can give you encouragement when you are heading in the right direction (i.e. reducing debt while increasing assets) and provide a wake-up call if you are not on track.
Ways to Grow your Net Worth.
So how do you effect your Net Worth in a positive direction over time? Recall the equation:
Net Worth = Assets - Liabilities
There are two parts that both effect your net worth in a positive direction:
- Increasing asset values
- Decreasing liabilities
Take advantage of both of those in order to grow your Net Worth. Here are some examples
- Pay down debt. The great news is that those monthly payments are adding to your net worth by paying down the principal balance. Some of the payment is going towards interest (not helping!) but with low-interest loans, much of each payment is going towards the principal. Using your cash flow to pay down debt is one of the best ways to increase your net worth because it focuses you from spending that income on fleeting items that don't add to your financial life.
- Be Responsible with Purchases. When you are considering things to buy, are they adding tremedous value to your life? Focus on the items and experiences that add significant value or even add to your net worth (using income to add assets!)
- Pay Attention to Assets and Liabilities. Make sure to understand both parts of the equation. By watching out for the opposite of net worth (decreasing assets and increasing debt!) - you'll become more financially aware of your actions.
- Make a Habit of Tracking. Check your net worth every so often (month, quarter or year). When you pay attention to a number, and the component parts, you will automatically make smarter choices. You are a product of your environment: use it to your advantage! Remind your conscious brain of what's important and the subconscious will play along.