If you aren’t brand new to the financial world, I’m sure you have heard the term “net worth” thrown around a time or two. It is commonly used by bankers, financial analysts, real estate investors, billionaires, and pretty much everyone in between in some form or another. But what is net worth exactly? How is it calculated? What is it used for? Why do I need to pay attention to my own net worth? I will answer all of these questions in this article in the hope of providing you with meaningful advice that you can take action on today.
Let’s start off with the definition of net worth. Net worth is simply defined as the difference between the value assets and liabilities that you own. To put it in a simple formula, it would look like this:
Net Worth = Personal Assets – Personal Liabilities
Basically, it is the difference between the value of everything that you own and all of the money that you owe to others. The listing of these items can be referred to as your personal “balance sheet”.
Now you may be wondering… Assets? Liabilities? Balance sheets? You’re speaking in jargon man, I don’t understand.
Well, let me break it down further.
Assets can be defined as anything that you own of value. Technically, this means anything, but for calculation purposes, I tend to stick to the larger ticket items. These items include your house, car, personal items like televisions, jewelry, and equipment, while also including investment items such as your 401(k), IRA, and brokerage accounts.
Liabilities are the exact opposite. I generally like to define liabilities as anything that takes money out of your pocket every month/year. This includes the mortgage that you have on your house, any auto loans, credit card debts, taxes due, etc. While it could be confusing to mix the two up, remember that no one thing can be an asset and a liability simultaneously.
For example, the house that you live in is an asset. The mortgage that you have on that house is a liability. The value of the asset and the liability will act independently of one another. You can pay down your mortgage balance every month to decrease its value, but that won’t directly correlate to an increase in the value of the house itself. The same is true of the opposite. The value of your house could tank by 15% in a given year, but your mortgage balance will not react accordingly. This independence is what allows you to either grow or lose wealth over time.
So now that we know the components to calculating net worth, let’s do a real world calculation so that you can get a better idea of how it works. In this example, I will be using estimates of my actual assets and liabilities as of Feb. 29, 2020, in order to get a rough idea of my own net worth.
First, let start off by listing my assets:
|Vehicle(s) – rough estimate||$15,000|
Next, let’s list my liabilities
|Credit Card Debt||$(1,000)|
Now we can put these two number’s together in our formula to find my net worth.
$35,000 (assets) – $(39,400) (liabilities)
Net Worth = $(4,400)
The final verdict is that my net worth is a whopping negative $4,400. However, I am not at all surprised by this number. Over the past year, I have been working extremely hard on paying back all of my credit card debt and have just recently transitioned to paying back my auto loan balances. While I am not in the positive net worth range yet, I am extremely happy with how reasonable this number actually is.
Personally, I am young in comparison to many people who are seeking financial freedom and my “balance sheet” shows that. I don’t own a home yet, so you can see that my largest liability is not a mortgage, but rather student loans. As time goes on, my balance sheet will adjust to the new liabilities and assets that I accrue, and as long as I don’t deviate too much from my plan towards financial freedom there won’t be anything to worry about.
Okay, we have discussed what net worth really means, how to calculate it, so now that leads us into discussion how to use the number that we just calculated.
Basically, you can use your net worth number in a ton of different ways. If you are applying for a loan for a big investment, banks typically want to see what your net worth number is (along with other major factors like credit scores, proof of income, etc.). You can also use your net worth as a health check on your finances to make sure that everything is in order. My personal favorite way to use my net worth number is a way to track my personal wealth over time.
You see, as you get started on your road to financial independence, you will want your net worth number to increase over time. Whether that is going from $200k in debt to $190k in debt, the goal is to make progress on becoming wealthier as time goes on. So a great way to use your net worth number in your life is to track your progress towards financial freedom.
There are multiple online platforms that will automatically track your net worth for you, so that you don’t have to do everything by hand. One of my personal favorites is the Personal Capital software that links to your checking and investment accounts in order to track your net worth automatically. The only drawback that I have encountered with this software is that they don’t allow you to manually enter the values of your personal assets such as cars, televisions, etc., so the number that you see will always be slightly skewed.
If you want to try out Personal Capital for yourself, feel free to click this link and set up a free account to begin tracking your net worth.
Also if you enjoyed this article, check out some of my other articles about investing and entrepreneurship here.