Remember the last time you went to your doctor for a physical? Did you ask her to skip the blood work, forget about your weight and don’t bother with your blood pressure? I didn’t think so.
How could you get a read on your physical health without tracking key health metrics? There are certain numbers that are so fundamental to understanding your underlying health status that they are virtual necessities.
Just like cholesterol levels and blood pressure readings are key components of your physical health status, net worth is one of the most important measures of your financial health status. If you want to build wealth over time, your net worth is the one key measure that you want to be tracking.
What is Net Worth?
For those of you that are not familiar with the term “net worth,” it’s a measure of wealth at a specific point in time. To calculate it, you simply add up all of your assets and subtract all of your liabilities (e.g. debts) and there you go. The difference in your net worth from one day to another will be the difference between what you spent and what you earned over that time period including any change in the value of your investments.
For example, your net worth on December 31st is unlikely to be the same as your net worth on January 30th. Your investments could have gone up or down in value, you would likely have made another rent or mortgage payment, you would have received another paycheck and you would have paid more bills.
Is a High Income the Same as a High Net Worth?
It’s interesting to consider that just because you have a high income, it does not mean that you have a high net worth. It has little to do with how much money you made or how much money you spent in a given year on an absolute basis, it’s the difference between the two that counts.
There are countless professionals that have taken out massive student loans to cover their educational expenses and have a negative net worth for decades after graduation. There are also many hard-working middle-class people that have consistently salted away their savings year after year and are already millionaires. You just can’t tell someone’s net worth by looking at them or inquiring about their profession.
How Do You Calculate Net Worth?
As I mentioned above, your net worth is calculated by adding up all of your assets and subtracting all of your liabilities (debts). The change in your net worth each month, quarter, and year will tell you how you are progressing financially and it will tell you how quickly you are approaching your financial goals.
If you are spending less than you are earning from year to year (and your investments haven’t tanked) then your net worth will be increasing – that is a good thing. That means you are getting closer to reaching your financial goals.
If you are spending more than you are earning, then your net worth is declining. That is a bright red flag that you may need to reconsider your financial strategies and decide if you need to make any course corrections. It’s always possible that you were hit by one-time investment losses or other events and your current strategy may be just fine – you will have to decide depending on the situation.
Common Personal Assets
An asset is anything of value that you own. Some common assets are:
- The home you live in and own
- The cash in your bank account
- The investments in your retirement or non-retirement accounts
- Any investment properties
A special note on cars – While cars are technically considered assets, unless they are collector items that have intrinsic value that may increase over time, for our purposes, I would not consider day-to-day cars as assets.
From a personal finance perspective, cars not only decline in value significantly over time but they increase your living expenses as well – that is a double hit to your net worth. The more cars you have, the greater the financial drain on one of your most important assets – your cash!
Common Personal Liabilities
A liability is anything that you owe and is also called debt. Some common liabilities include:
- A mortgage on your primary residence
- Loans on investment properties
- Car loans
- Student loans
- Credit card debt
Calculating Your Net Worth
Once you’ve calculated your assets and liabilities, the math is simple enough. Just subtract your liabilities from your assets and see where you are. Even though the math is simple, the implications can be striking for people that are not used to thinking about their net worth.
- If you take $5,000 and make an extra payment to reduce your mortgage, you may feel poorer because you’ve drained $5,000 from your bank account. In reality, your net worth has not changed because you now owe $5,000 less on your mortgage. You’ll end up paying less interest on that loan over time which will be a positive boost to your net worth in the future.
- If you buy a nice new $40,000 car, you may feel richer enjoying that new car smell and rolling down the street in your new wheels. Your net worth, however, just went down by $40,000 (according to my definition cars are not assets). Also, your annual expenses will probably go up for gas, automobile insurance, and maintenance.
Automating Your Net Worth Calculations
Like most things these days, there are several ways to have your net worth calculated for you automatically. If you are just starting off down the path towards financial independence, I would highly recommend that you calculate it yourself a few times first. You can either calculate it by hand or in Excel just so that you understand how the calculations work.
Here are a few good options to automate your new worth calculations:
- You can run software like Quicken on your personal computer which is the way I go. Generally, you have a little more power and control over reporting and analysis with this approach.
- You can sign-up for a free account at Mint which will aggregate all of your accounts in one place online and will help you to set budgets and manage bills.
- You can also sign-up for a free account with Personal Capital which not only aggregates your accounts online but also helps you to make sure you have your investable assets allocated appropriately. This service is geared more towards the individual with a larger retirement account to invest. I have an account here and love it!
You can always use a combination of services. I have been using Quicken to track our household finances for over a decade. I have it setup just how I like it and it works for me. I have recently added Personal Capital to the mix and it helps me to make sure I am optimizing my investment portfolio. I also use Excel a few times a year when I want to do some hard-core number crunching. Using all three works well for me, but you’ll have to decide what works for you.
Do you agree that tracking your net worth is a key personal financial measure? What is your net worth? Which service do you use to calculate it? Have you ever calculated your net worth manually?