What Is Net Worth Complete Guide

What Is Net Worth Complete Guide SAT / ACT Prep Online Guides and Tips If you’ve ever analyzed your personal finances, you may have come across the term â€Å"net worth.† Simply put, your net worth is what you have minus what you owe. While net worth is a useful way to evaluate your financial situation, it also has some major flaws. Let’s define the concept of net worth, and then look at some key adjustments you can make to assess your finances and plan for the future even better. What Is Net Worth? A Hard Definition You just read a simple definition of net worth: what you have minus what you owe. Let’s rename â€Å"what you have† as assets and â€Å"what you owe† as liabilities. Let’s say your major asset is a $10 lemonade stand. Your major liability? The $4 you owe to your mom for sugar and lemons. Overall, your net worth is $6. Not bad for a 7-year-old budding entrepreneur. Twenty-five years later, your assets and liabilities probably look a little different. You lost the lemonade stand, but you collected other assets, like a savings and checking account, a car, a sweet road bike, and several rare Beanie Babies that you had the foresight to save. While you’ve paid off that $4 debt to mom, you’ve amassed some other liabilities: namely a hefty car loan and an even heftier student loan. Your net worth is the total value of all your assets minus the total value of all your liabilities. Using this example, let’s break down the steps to calculating your net worth. Calculating Net Worth: An Example Considering our 32-year-old friend who, sadly, did not grow up to run a lemonade stand empire (let’s call him Joe) we can list out all his assets and liabilities. Next to each one, we assign their current market worth. All of Joe’s assets together add up to $27,000. Again, these values represent the current market worth; who knows what the volatile Beanie Baby market is going to look like tomorrow? His liabilities total $35,000. The chart below shows the breakdown of Joe’s assets and liabilities beside their current values. Assets Current Market Worth Liabilities Current Market Worth Checking account $2,000 Car loan $5,000 Savings account $6,500 Student loan $30,000 Car $15,000 Road bike $1,000 Beanie Babies $2,500 Total: $27,000 $35,000 Net worth = assets - liabilities = $27,000 - $35,000 = - $8,000 After subtracting his liabilities from his assets, Joe is left with a negative net worth totaling $8,000 in debt. While ending up with a negative net worth isn’t ideal, it’s not actually unusual or even necessarily a bad thing, especially at certain points in life. In fact, Joe looks like he’s in a pretty good financial spot, especially if he keeps making consistent payments toward his car and student loans. So how can you calculate your own net worth? Read on for each step of the process. How to Calculate Your Net Worth: 6 Steps To calculate your own net worth, you need to go through the same process as Joe. There are six steps: Step 1: List Out All of Your Assets These could be tangible things like houses, cars, motorcycles, bicycles, land, pleasure yachts, baseball cards, rare coin collections, Basquiat paintings, fur stoles, gemstone-encrusted goblets...you know, the usual. They could also be intangibles, like stocks or other investments. Step 2: Determine Current Market Worth Once you’ve identified your assets, determine their current market worth. Don’t value your car at the amount for which you bought it, for example. Instead, find out what you could sell it for now. Step 3: List All Your Liabilities These could be student loans, personal loans, car loans, mortgages, or credit card debt that you amassed paying for all those pleasure yachts. Step 4: Determine Your Debts As you did with your assets, assign the amount of money that you currently owe to each liability. Step 5: Subtract Assets from Liabilities Figuring out your net worth is a simple subtraction problem: total value of assets minus total value of liabilities. Then you have your net worth! If you end up with a negative net worth like our friend Joe, it isn’t necessarily a bad thing. Lots of recent graduates, for instance, will be in this position thanks to ever-growing student loans. Your net worth doesn’t account for changes in your earning and spending over time, which is one of its major limitations. I’ll discuss the pros and cons of net worth in more detail below, so if you’re only interested in the hard definition of net worth, you should stop reading here. If you want to know how to make a more realistic assessment of your finances in both the short and long term, though, then you should keep scrolling. Before getting deeper into net worth, a quick note about my background in finance and economics. My Background in Finance and Economics I’ve invested my higher educational life to studying the ins and outs of economics. At Harvard, I got my Bachelor’s in Math, Master’s in Statistics, and Ph.D. in Economics. Eager to put theory to good use, I started a personal finance circle in my community to help struggling neighbors get on the path to financial independence. Along the way, I’ve deftly managed my business PrepScholar’s cash flow and my own personal finances. For many of us, school teaches us a lot about critical thinking, but very little about how to manage our money. With my background, I sincerely hope to assist others in developing solid financial planning skills. Now that you know a little about me, let’s return to the topic at hand: net worth, why it’s a useful metric for understanding your personal finances, and where it falls short. Why Is Net Worth Useful? 2 Main Reasons Calculating your net worth is a traditional approach to measuring your financial standing. It’s relatively easy to calculate, and it shows you the balance between your assets and your debts. If you calculate your net worth several times throughout the year, then it also suggests a pattern in your financial worth. Let’s take a closer look at the two main uses for this framework of net worth. Reason #1: Net Worth Reveals Your Current Financial Standing Net worth gives you a big picture view of your financial profile at a specific point in time. It makes you take stock of what you have and what you owe. If you were to sell off everything you owned and put it all toward paying off what you owe, you’d have your net worth left over- whether it’s cash in your pocket or remaining debt. Realistically, you’re probably not going to trade in all of your earthly positions, move into a log cabin, and pull a Henry David Thoreau, but you do know what your safety net looks like if you were to experience a big financial change, like getting laid off. Calculating net worth gets you to identify your assets and liabilities, connect the dots between them, and understand your financial standing at a particular moment in time. Reason #2: Net Worth Shows Patterns Over Time A one-time calculation of net worth only tells you about the present, but comparing your net worth over time reveals patterns in your earning, saving, and spending. If you were to determine your net worth three times over a year, then you could see how it changes. Imagine your net worth as a see-saw with assets at one end and liabilities at the other. If the see-saw tilts down toward debts, then you can consider ways to level it off over time, perhaps by reducing your monthly spending. If it’s starting on the upswing toward assets, then you can strategize about how to keep that progress going. By calculating your net worth several times over a set period, you can identify patterns in your finances. As a result, you can think about lifestyle changes that would help you yield a higher net worth the next time you sit down with your calculator. All that being said, there are also some major flaws in the concept of net worth. It contains some big blind spots, and it’s important to know what these are so you don’t miss the forest for the trees. Read on to learn how net worth paints the big picture, but overlooks some of its most important details. How Is Net Worth Limited? 3 Major Flaws The idea of net worth misses a few major parts of your life. When it talks about assets and liabilities, for instance, it misses a pretty major one: you! Net worth completely overlooks all the money that you’re making and spending now and in the future. By focusing solely on assets and liabilities, it fails to take into account the human element. Net worth also doesn’t distinguish between types of assets. Some assets get more valuable over time, while others are like a slowly sinking pleasure yacht. Let’s take a closer look at net worth’s three major flaws, and then discuss some excellent ways to fix them. Flaw #1: Net Worth Misses One Huge Asset Don’t take it personally, but net worth completely overlooks you as an asset. It focuses on things that you possess, but it ignores your labor income now and in the future. Let’s say you make $30K a year. If you maintain that income, then you’ll bring in $300K over the next ten years. Realistically, you’ll probably bring in even more as your skills, experience, and earning potential grow over time. Net worth overlooks all of this income. Consider a second example. Alex has $10k saved and no debt. Britney, though, is $100K in debt. According to the traditional net worth definition, Britney is in a way worse financial position than Alex. However, Alex makes $20K a year, while Britney, who’s in debt because she went to medical school, just got a guaranteed $200K per year job! It’s Britney, ultimately, who’s in the superior financial position. The traditional net worth formula, though, doesn’t show it. For many people, especially those in their 20s and 30s, labor income is their primary asset and thus the most important metric when analyzing personal finances. I don’t have a wide array of tangible assets, like a collection of antique motorcycles or Renaissance art. My human capital is, by far, the most relevant asset when assessing my financial standing. If I only used the traditional equation of net worth to measure my finances, I would be overlooking my most important asset. Flaw #2: Net Worth Doesn’t Include Baseline Spending Just as net worth ignores you as an asset, it also overlooks you as a liability (no offense). Your basic consumption- groceries, shopping, climbing gym membership- accounts for major drains on your budget. If you need $20k of baseline spending per year, then you’ll be spending $200k over ten years. Like your income, your basic consumption has a huge influence on your finances. Net worth takes into account big liabilities, like mortgages, student loans, and credit card debts, but it doesn’t acknowledge smaller ones that add up over time. It doesn’t incorporate your baseline spending, which might be a much more relevant metric to lots of people than, say, a bulky mortgage on a farmhouse in upstate New York. Flaw #3: Net Worth Doesn’t Distinguish Between Types of Assets Finally, net worth is a static measure that doesn’t account for the fluctuating values of your assets. Let’s say you have a $20K yacht and $20K in a stock index. When calculating your net worth, these two assets look exactly the same. If you sold everything off that day, both would give you $20K each in your pocket. If you’re trying to make a realistic and forward-thinking assessment of your finances, though, should these two assets really be considered on an equal level? I would answer with a hard no. The boat costs $4K a year to maintain. Your investment is likely to get $1K or more in returns. Since it’s sapping money and losing value over time, the boat is a consumption asset. The investment, on the other hand, is a productive asset. Distinguishing between consumption and productive assets is one way to fix this flaw in the net worth system. Read on for a full breakdown of how to calculate net worth in a way that’s more realistic and useful for your long-term planning. How to Calculate Your Net Worth Better Now that I’ve exposed net worth’s flaws, let’s talk solutions. There are two main adjustments you can make to improve this assessment, the â€Å"Total Net Asset† fix and the â€Å"Productive Net Worth† fix. Let’s look at both in more detail. Fix #1: Total Net Asset Fix As you read above, the standard analysis overlooks you completely. It doesn’t account for the two largest levers to improve yourself: increasing your earning power and decreasing your spending habit, two important topics that I’ll explore in other articles. To fix this oversight, you should estimate the next 10 years of your earnings and baseline spending. Ten years is long enough to give you a good idea of your finances, while short enough that you can make a realistic prediction. If you make somewhere in the range of $40K a year, then you could estimate that your income over the next ten years will add up to $400K. If your annual baseline spending adds up to $20K, then you’ll be spending at least $200K over the next decade. Of course, changes in your income and spending will happen; that’s the whole point. This long-term projection lets you take control of your personal and professional choices, because it reveals just how much a raise in salary or cut in spending could affect your long-term net worth. The Total Net Asset fix gives you better insight into your finances, and it lets you think in a more forward-thinking way about your choices. You can play around with a few estimates to see how changes, both small and big, could increase your worth over time. Fix #2: Productive Net Worth Fix The second solution, which I’m calling the Productive Net Worth fix, helps distinguish between productive assets that gain value over time and consumption assets that lose value over time. I would suggest a somewhat radical departure from the traditional net worth equation. Instead of counting all of your assets, only count your productive assets. These might be money in your bank accounts, cash, stocks, and any investment properties. The consumption assets you’d leave out include a house, car, or boat. The way you use these consumption assets on a day-to-day basis (to live, drive, or throw lavish pirate-themed parties, respectively) is their primary value. Since they both cost money and depreciate over time, they should be left out of the net worth equation. (Side note: you might wonder if a house should be counted as a productive asset. Robert Kiyosaki, author of Rich Dad, Poor Dad, gives a convincing argument on the house-as-liability side. According to Kiyosaki, a liability is â€Å"anything that takes money out of your pocket.† Because of all the upkeep and repairs they require, houses can often be considered a consumption, rather than a productive, asset.) Now that we’ve gone over both adjustments, the Total Net Asset and Productive Net Worth fix, let’s put both of them together to see how you can make the most realistic assessment of your financial worth both now and in the years to come. Measuring Net Worth: A More Realistic Assessment Let’s bid farewell to Joe and consider a new exemplar, Stacy. Stacy has a $20K car, $10K in savings, a $5K student loan, and a $1K personal loan. Here’s her list of assets and liabilities alongside their current market values: Assets Current Market Value Liabilities Current Market Value Car $20,000 Student loan $5,000 Savings $10,000 Personal loan $1,000 Total: $30,000 $6,000 Using the traditional calculation, Stacy has a net worth of $24,000 ($30K - $6K). Based purely on the hard definition of net worth, Stacy could theoretically raise her net worth by upgrading her car. Since we now know that a car is a consumption asset that both costs money and loses value over time, this approach would be a questionable one. The traditional definition of net worth is trying to lead Stacy astray! Let’s fix that. Using our Productive Net Worth fix, let’s eliminate the car completely from our assessment. Then we’ll apply the Total Net Asset fix and add in Stacy’s projected income and baseline spending over the next ten years. We estimate that her income will be $300K, and her spending will add up to $200K. Assets Current Market Value Liabilities Current Market Value Savings $10,000 Student loan $5,000 Projected income $300,000 Personal loan $1,000 Projected baseline spending $200,000 Total: $310,000 $206,000 Stacy’s new net worth over 10 years is $104K. Rather than giving her a one time balance of her assets and liabilities, this â€Å"fixed† net worth assessment helps Stacy figure out her finances over the long-term while incorporating her most important asset and liability, her own labor income and spending. With this estimate, Stacy can begin to think more realistically about her long-term value and how to improve her position. What can she do to yield a net worth higher than $104K over the next ten years? Some strategies for increasing net worth over the long-term are all fodder for another article, but a few key ones include, Improving her earning potential through education and skills training, Making cuts to baseline costs, Eliminating debts, and Avoiding the purchase of consumption assets. Sorry, Stacy, but you probably shouldn’t buy that state-of-the-art Jetski with your current balance of $24K; it’s only going to eat away at your long-term net worth. In closing, let’s review the key points you need to remember about net worth, its traditional definition, and the adjustments you can make to get an even more realistic assessment of your long-term financial profile. Calculating Your Net Worth: What You Need to Remember The concept of net worth helps you balance your assets and debts and evaluate your financial standing. The traditional formula has you simply subtract the sum of your debts from the sum of your assets. While this approach has some uses, it’s not nuanced enough to truly help individuals with their personal finances. Nor does it apply to lots of people whose primary asset is their own labor income. In fact, the net worth formula is a vestige of corporate accounting and much more relevant to businesses than to you or me. By making a few adjustments- namely, by estimating future cash flow and distinguishing between consumption and productive assets- we can make the net worth formula work much better for us. Then we can use this analysis to inform our financial choices. Rather than solely looking at little-picture changes, like cutting out morning lattes at Starbucks, we can focus on big-picture changes that have a great long-term effect, e.g. increasing our earning potential with a new degree, paying off high-interest credit card debt, and resisting the urge to buy a boat. With a couple key fixes to the traditional formula of net worth, we can look outside the present moment and gain a long-term idea of our economic worth. The result? Smart financial choices now that will benefit us substantially in years to come.