Net worth is probably the single most important measure of personal wealth, which is why knowing your net worth is so important. This is particularly true if your plan is to increase your wealth in order to achieve financial independence and reach retirement. But what is it exactly and how do you calculate it?
What is Net Worth?
In its simplest form, net worth is the difference between your assets and your liabilities.
When put into a mathematical equation, it would look like this:
Assets – Liabilities = Net Worth
If you have $200,000 in total assets, and $125,000 in total liabilities, your net worth would be equal to $75,000 ($200,000 – $125,000).
Why Net Worth is Important
Though many people never bother to calculate their net worth, everyone really needs to. There are at least six reasons why knowing your net worth is important:
1. Net worth is the most accurate measure of wealth. Wealth is what is left over after all of your bills are paid — and that’s precisely what net worth is all about. There’s no way to know exactly how wealthy you are without knowing what your net worth is.
2. Tracking your financial progress. Since net worth is a specific number able to be tracked with precision, it enables you to measure your financial progress from one month or year to the next. A growing net worth is the best sign you’re moving forward; a decline in net worth means you have more work to do.
3. Moving the financial focus beyond income alone. The concepts of wealth and prosperity are often grouped by income levels. While this measure has some value, it doesn’t take into account expenses, taxes, or other specifics. Even if your income is growing, if your net worth is flat or declining, your financial situation may not be improving at all.
4. Avoids over-emphasis on asset value alone. Some people focus almost exclusively on the value of their assets as a measure of their personal wealth. For example, they may proudly proclaim $250,000 in assets, while ignoring $200,000 in debt. It is not the size of either number that counts, but rather the difference between the two.
5. Puts your debt level in proper perspective. In a perfect world, we should all be debt free — but that’s not quite the way life works. A large debt number can seem scary, but if it is more than offset by a large asset position, it’s not nearly as bad as it looks. For example, if you have $50,000 in debt — and $250,000 in assets — your debt level probably isn’t extreme.
6. Net worth can be important when applying for a loan. Since net worth is the best measure of overall financial strength, lenders are often interested in knowing what it is in determining whether or not they will approve you for a loan.
How to Calculate Your Net Worth
There’s nothing complicated about calculating your net worth — it’s mostly a basic math equation.
Start by adding up your assets.
Liquid assets. This will include cash on hand, cash in the bank, certificates of deposit, treasury bills, money market funds, and any other cash equivalents.
Retirement investments. This will include employer-sponsored retirement plans, such as 401(k) and 403B plans, as well as personal retirement assets, such as traditional or Roth IRAs or solo 401(k)s.
Non-retirement investments. This will include any investment assets you own that are not held in a retirement plan.
Real estate. This includes the market value of your primary residence, as well as any other property you own, either for investment or for pleasure. Keep in mind real estate prices can fluctuate from one year to the next. It is generally best to be at least somewhat conservative in your estimates. If you have no idea, you can try going to a valuation website such as Zillow.com.
Business assets or equity. If you are a business owner, you may want to include the net worth of your business, or of any significant business assets you have. Be careful here though — business equity and assets aren’t always readily convertible into cash. There can be an enormous difference between accounting value and market value of a business or its assets.
Personal assets. These can be cars, furniture, jewelry and other personal effects. Many people do not include these in their net worth calculation either because they have no intention of ever selling them, or because they have very little resale value. If you include them, be especially conservative.
Personal loans receivable. These are loans you have made to family, friends, or business associates. Include them only if there is a reasonable likelihood of collection.
Other assets. This can include assets that don’t quite fit in any of the above categories, such as the cash value of any life insurance policies.
Next, add up your liabilities.
Mortgages. This includes the first mortgage on your primary residence, but also a second mortgage or home-equity line of credit, if you have any. Be sure to include outstanding mortgages on any investment or recreational property as well.
Installment loans. Car loans are the first to come to mind, but you should also include any other installment loan arrangements you have on any other possessions, including furniture, boats, or motorcycles.
Student loans. Include these, even if you are just a cosigner for one of your children.
Credit cards. If you’re tracking your net worth on a continuous basis, you’ll have to monitor these closely. They represent revolving debt, which means the balances are constantly changing.
Business loans. Chances are high any loans you have outstanding for business purposes are also a personal liability, and should be included in your calculation of net worth.
Personal loans. Include the outstanding balance of any loan you have received from a family member, friend, or business associate.
Other liabilities. This can include medical debts, tax liabilities, or any other obligations that don’t fit neatly in any of the above categories.
Once you have tallied up the complete numbers for both your assets and liabilities, subtract your liabilities from your assets, and that will give you your net worth.
How to Improve Your Net Worth
Calculating your net worth can be an intimidating experience, particularly if the net worth number is either low or negative. But net worth is simply a number that exists today, and you can change it in the future.
In fact, the whole idea of calculating your net worth is to establish a baseline from which you can improve your financial situation.
There are two ways to improve your net worth:
- Increase your assets, and/or
- Decrease your debts
You can do this in any combination you choose — building up your assets while keeping your debts level, paying down your debts while keeping your assets level, or a combination of both.
Always remember where you’re taking your net worth is more important than where it is right now.
Do you track your net worth on a regular basis?