What Is Net Worth & Why Does It Matter?
What is net worth?
Net worth is a simple calculation that gives you an overview of your financial health and your wealth. The simple equation is assets minus liabilities, or in other words, what you own minus what you owe. The higher your net worth, the wealthier you are.
The equation written out would look like:
assets – liabilities = net worth
Why is net worth important?
OK, so that sounds like boring math, so what’s the big deal about it anyway? Here are four reasons why knowing your net worth is important.
1. Net worth is one of the most accurate measures of wealth.
Net worth is important because it is one of the best indicators of wealth. Think of it as the big picture of your finances.
When it comes to net worth, bigger is better. Positive net worths are good, and the larger they get, the wealthier you are. It is entirely possible, and quite common, to have a negative net worth.
In order to retire, you need to have a positive net worth and enough assets to provide income to support your lifestyle while you’re not working. A negative net worth means that you need an active income from a job to pay your debts every month.
2. Net worth helps you track your financial progress
Knowing your net worth right now helps you understand if you are wealthy at this moment. Tracking the trajectory of your net worth over time helps you see if you are becoming wealthier or poorer.
By tracking your net worth, you can measure your financial progress from month to month and year to year. If your net worth is increasing, you’re improving your finances and moving forward. If your net worth is decreasing, your finances have taken a turn and you have some improvements to make.
3. Net worth moves the focus beyond income
If you only look at one aspect of your finances, like your income, you might think, “hey, I’m doing really well, I make a lot of money.” But without considering your expenses, it’s actually impossible to tell if you’re doing well, because you don’t know how much of that money that you’re earning is left over at the end of the month.
Would you agree that someone who makes $100,000 a year is wealthy? How about when I tell you that they spend $150,000 a year? Now, you might not think so.
4. Net worth puts your assets and liabilities into perspective
Net worth helps you put your whole financial situation into perspective. It prevents over-emphasizing the value of your assets as a measure of wealth. If you have $500,000 in assets, but ignore that you’re $450,000 in debt, you’re not seeing the full picture of your wealth.
It’s not either number that is important by itself, but the difference between the two. The same goes for putting debt in perspective. If you have $50,000 of liabilities, but $500,000 in assets, your debt is not as extreme as you might have thought by looking at that number alone.
Assets vs. Liabilities
Let’s dive into those terms, assets and liabilities, because defining them will help you calculate your net worth.
According to Robert Kiyosaki, the author of Rich Dad, Poor Dad, assets are anything that put money in your pocket. Liabilities are anything that take money out of your pocket.
Simple, right? This helps differentiate between things that seem like assets, such as houses or cars, but are actually liabilities costing you money in the form of a debt payment or other overhead expenses every month.
Assets
Liquid Assets: These include the cash in your wallet, money in the bank, certificates of deposit, money market accounts, and any other cash equivalents.
Investments: This includes investments like stocks, bonds, and commodities inside retirement plans like 401ks, 403bs, traditional IRAs, Roth IRAs, or taxable investment accounts.
Real Estate Investments: If you own real estate that you are renting for income, this is an asset, because it is putting money in your pocket. See below for primary residences.
Liabilities
Houses: Primary residences cost you money, they don’t earn you money. You spend money every month on your mortgage, taxes, and insurance plus repairs and maintenance. Even if you own your house outright, it is costing you money on a monthly basis for taxes, insurance, repairs and maintenance. Vacation properties or second homes are the same way. Unless you are earning more money on your house than you spend on it, your house is a liability. I discuss some ways you can earn money on your primary residence (to turn it into an asset) in Episode 37.
Cars: Cars cost lots of money to operate and maintain. You have to insure them, do maintenance, pay for gas, and more. It’s pretty clear that cars take money out of your pocket, even before you consider factors like depreciation, which is where the value of the car decreases over time. This article covers ways to save money on transportation.
Boats, ATVs, and other big toys: Just like a car, there are costs to keeping, operating, insuring and maintaining these belongings. And, many people get installment loans to pay for these toys, which means they are carrying debt which is a liability.
Credit card balances: Fashion, jewelry, and furniture are often items that people might think of as assets, but they are in fact liabilities. And, they are often purchased on credit cards. Whatever else you buy with your credit card, including subscriptions, groceries, and gas, is bought on credit, and you have to pay it back from your cash assets, so credit card balances are considered liabilities.
Student loans, business loans, personal loans, and payday loans: All types of debts are liabilities, because they take money out of your pocket. Other liabilities might include tax liabilities or medical debt.
How to calculate your net worth:
Now that we’re clear on what is an asset and what is a liability, you can do your net worth calculation. To do so, add up all of your assets, and then subtract all of your liabilities.
There’s an easier way to do this than on paper or in a spreadsheet. It also makes tracking your net worth over time much easier.
Use a tool like Personal Capital to track your net worth. On this website, you connect all of your bank accounts, loans, investment accounts, and more, and the program will automatically update with your net worth. Since investment values can fluctuate daily, you will be able to see an accurate net-worth whenever you log in, because the calculation is automatically up to date. Additionally, you can add the values of your assets that don’t have accounts, like the fair market value of your home or car.
Tracking your net worth
Why should you track your net worth? When you figure out your net worth for the first time, you’re getting the big picture of your financial situation at that moment. But when you track over time, you can see if your financial situation is getting better or worse.
If you’re saving more than you’re spending, you will see positive progress over time as long as you’re not taking on additional debts. But if you see that your net worth is decreasing, that means you’re spending more than you are saving or you’re taking on additional debts. This downward trend can tell you that it’s time to change something in your financial life in order to start building wealth.
It’s also really encouraging to track your net worth when you’re pursuing a financial goal such as debt payoff, early retirement, or standard retirement. By seeing the progress you’ve made each month, you can see how quickly you’re moving towards your end goal!
When I first calculated my net worth, it was -$100,000 (that’s negative six-figures!). While that was helpful to see where I was, I could also track my net worth to measure whether I was heading in the right direction. Since I was putting all of my disposable income towards my student loans, I wasn’t growing my assets, but by decreasing my liabilities, my net worth become less negative. This was an upward trend, that allowed me to see that I was making financial progress.
When I stopped aggressively paying down my debts and started to invest, I was still seeing forward financial progress. After a while, my net worth crossed from negative to positive, and continued to grow.
Improving Your Net Worth
There are two ways to improve your net worth: decrease your liabilities and increase your assets.
Decrease Your Liabilities
By decreasing liabilities, you will see your net worth increase. You can do this by paying off debt or selling liabilities (if they have value) to pay off debt and remove monthly payments. Another important part of decreasing your liabilities is not adding to them. That means not taking on additional debts, such as credit card debt or loans.
When I first started tracking my net worth, I had hardly any assets, and a ton of debt. As I started paying my debt off, my liabilities decreased. This means that the negative side of the equation got smaller, and so my net worth grew from negative $100,000 to negative $50,000 to negative $25,000.
Increase Your Assets
You can increase your assets by saving cash or increasing your investments. Saving a buffer in your checking account will increase your assets, and bring your net worth up. So will saving an emergency fund or saving towards another goal. Investments are a really great way to increase your assets, because they grow passively due to compound interest. If you invest when you are young, you have lots of time to see compound interest take effect and increase your assets for you.
Once I paid off the high interest portion of my student debt, I still had a negative net worth. To get to a positive net worth, I started saving. First, I saved an emergency fund. Then I started saving and investing at the same time. Every time I got a paycheck, a percentage would automatically be invested in my 401k. I would put some in the bank towards my savings goals, and I started to invest in an IRA.
That whole time, I was also paying my minimum payments on my remaining student loans, which decreased my debts a little more each month. By increasing my assets, I saw my net worth grow from negative $100,000 to $0, and then to $10,000, $20,000 and $50,000. Most of that increase was from me actively saving and investing, but I did gain some net worth from my investment assets increasing in value thanks to compound interest.
What should your net worth be?
This is a common question. We all want to know how we’re doing compared others, right? However, I’ve found that common answers to this question are unsatisfactory. The first problem is that generalized advice can’t possibly take into account your personal goals. Often, the recommendations you will find online are based on a traditional trajectory of working 9-to-5 until 65. But if you’re finding your freedom outside of that norm, the regular advice may not apply.
The second problem is that they’re almost always based on your income, not your expenses. That’s because they assume that most people spend nearly everything they earn. However, if you want to see how long your assets can sustain your lifestyle, you need to think of it in terms of how much you spend. And if you’re building wealth, you’re not going to be spending every cent you earn.
Finally, if you follow the traditional net worth recommendations, you wouldn’t be able to afford to take time off from work, like a sabbatical or mini-retirement, or retire early. By increasing your assets while you’re young, in your 20s and 30s, instead of waiting until your 50s and 60s, you can have compound interest on your side to help boost your net worth passively.
Here’s what’s commonly recommended. In your 20s, just try not to take on too much debt. By 30 you should have half of your salary in net worth. By 40, you should have two times your annual salary, by 50 4 times your annual salary, and by 60 you should have six times your annual salary. Then you can retire at 65.
What I recommend will depend on your personal situation. I think your 20s and 30s are the best time to grow your net worth so that you can sit back and relax while compound interest does it’s thing.
If you start to think about net worth in terms of expenses, not salary, you’ll need a net worth that includes assets equaling approximately 25 times your annual expenses to retire. You’ll want to base this number on a conservative (high) estimate of what you think you will spend in retirement.
How quickly you get to that number depends entirely on your personal goals, lifestyle, income, and expected expenses in retirement. I know people who are retiring with 25 times their annual expenses by age 30 or 32. This is called early retirement or Financial Independence, Retire Early, aka FIRE.
I personally decided that I wanted to reach CoastFI, which is where I have enough invested in my retirement accounts that it will grow to be 25 times my annual expenses by the time I’m 59 ½. I reached CoastFI in February 2020. That means from now on, from age 26 to 59 ½, I only need to earn enough active income to support my expenses. Since my expenses are very low, I only need to do part time or seasonal work to afford my lifestyle. If I earn more, I can invest the extra, and either have more to spend in retirement, or retire earlier.
In the end, you need to decide on your personal net worth milestones, instead of measuring your progress on someone else’s yardstick.
Conclusion
There are many paths you can take to financial freedom. Once you decide your path, you can create a plan and timeline that you will measure with certain net worth milestones. Remember, you’re not racing with anyone else. Your net worth should be a compass to help you see if you’re headed in the direction of YOUR goals.