Are you new to the world of personal finance? Not quite sure what all the technical terms mean? You are not alone, I’ve also been there!
When I first started my own personal finance journey, I was a bit overwhelmed by all the different concepts. What does “net worth” mean? What’s an index fund? How do I measure my savings rate? And what is this FIRE thing everyone seems to be talking about?
If that’s what’s going on in your head right now, don’t despair! I’ll break down the main personal finance concepts in an understandable way in this Personal Finance Basics article series. For each concept, I’ll also provide an easy-to-follow example for you.
Hopefully, these articles will help you gain some clarity on what is what and turn the technical terms from daunting to delightful.
Up first: What is Net Worth and why should I care?
The concept of net worth is one of the best ways to summarize your financial situation. It can also serve as an indicator of financial health. Checking your net worth every once in a while can help you verify if you are moving in the right direction. Ideally, your net worth should be growing over time.
So what is net worth, exactly? In mathematical terms, net worth is defined as your total assets minus your total liabilities. To put it in simpler terms, your net worth is the difference in value between everything that you own and everything that you owe.
To fully understand net worth, we must first understand the two components that it is calculated based upon: Assets and Liabilities
What are Assets?
Fundamentally, everything that you own that is expected to provide some future (monetary) benefit to you is an asset. To put it more simply – everything that you own that you could sell in exchange for cash, as well as cash itself, is an asset.
Some assets are depreciating, which means that they tend to lose value over time. An example for such an asset would be a new car. As you may know, the moment that a new car drives off the dealer’s lot, it loses a bunch of its value. At that point it is no longer “new”, and you would not be able to sell it at the same price that you bought it for. As you drive the car for more and more miles, the value for which you can still sell the car to someone else generally continues to drop. That’s why a car is a depreciating asset.
Other assets, such as stocks, would generally be expected to appreciate, which means that they would tend to become more valuable over time.
In general, it is a good thing to own more, ideally appreciating, assets.
What are Liabilities?
While assets refer to everything that you own, liabilities refer to everything that you owe to someone else. Usually, that would be money. Examples of liabilities can include student loans, car loans, mortgages or credit card debt.
Of course, it would generally be preferred to have less liabilities. Some personal finance writers differentiate between “good debt” and “bad debt”, where “good debt” is associated with (ideally appreciating) assets, and “bad debt” is not. Based on that, a mortgage could be considered “good”, while a credit card liability could be considered “bad”. Opinions differ on this though.
One thing is always true: The less liabilities that you have, the higher your net worth will be.
Ok great, so how do I compute my net worth?
Remember that your net worth can be calculated as your assets minus your liabilities.
Therefore, the first step to calculating your net worth is calculating the value of all of your assets. Remember, assets refers to things that you own that can be sold for cash.
Usually, we would not include regular household goods in this computation. Rather, we tend to focus on “big ticket” items with higher resale value (your house, your car), cash or cash equivalents (think traveler’s cheques) as well as investment type assets (stocks, bonds, gold, index or mutual funds and even your pension savings). Of course, if you own something with a high resale value that does not neatly fit into one of the boxes like a coin collection, jewelry, power tools or similar, you can still include it if you want.
The second step would then be to calculate your total liabilities, meaning, take stock of everything that you owe to someone else.
Once you’ve understood both your assets as well as your liabilities, you can easily compute your net worth based on the formula.
Let’s look at an example.
Erica Example wants to calculate her net worth. That means that first, she needs understand how many assets she owns. She takes a moment to write down everything that she can think of that falls into that category. Here is what she comes up with:
- Her car
- The money in her current account
- A tax-advantaged employer pension account
- A stamp collection passed down to her from her grandmother
- Cash in her wallet
Some of these are easy to evaluate and some are harder.
Let’s start simple: The cash in her wallet is worth exactly what is printed on it. Erica finds that she has $80 in her wallet right now. Also, in order to check the value of the money in her current account, Erica just needs to log into her online banking. She takes a look at her balance, and it turns out she has $4,329 saved up in her current account. Good going, Erica!
To understand the value of her tax-advantaged employer pension account, Erica can also check the balance. However, valuing this account is slightly less straight-forward. The simple thing to do is to just use the exact balance, but in most cases, this is not a true representation of the current value. Why? Because tax-advantaged pension accounts often cannot be accessed until a certain age, or, if they can be accessed early, this might come with a penalty or a tax liability. For Erica’s case, she decides to keep it simple and just go with the balance value of $7,885. Nice one!
For her car as well as the stamp collection, things get a little bit more complex. In order to account for these assets in her computation, Erica needs to determine what she could sell them for. It’s important not to overestimate the fair market value, otherwise the resulting net worth number will be too high.
An asset like a popular car model can still be relatively easy to value. Often, the resale value can be estimated quite reliably, based on mileage, age and condition of the car. Estimating the value of something like a stamp collection can be more difficult. One way for Erica to approach this would be to get the stamp collection appraised, which means having the collection it evaluated by an expert.
Erica takes a look around the internet and determines that she could probably sell her car for $4,500. For her late grandmother’s stamp collection, an appraisal comes back at a value of $500. Not bad!
Now Erica can sum up her assets:
Next, Erica turns to understanding her liabilities. The list that she comes up with includes:
- Her student loan
- Her credit card balance
- Her car loan
After reviewing her paperwork, she quickly finds out the amount that she still owes on each of these items and then computes her total liabilities:
Now that Erica has understood both her assets as well as her liabilities, she’s ready to compute her net worth by following the formula:
It turns out that her net worth is positive. Yay!
Erica owns more than she owes, which is great. However, her net worth is also quite small. While she could likely pay back all her debts immediately by selling everything that she owns, she is not yet in a very comfortable financial position.
Therefore, Erica decides to focus on growing her net worth over time, by building up assets and reducing liabilities. She also makes a promise to herself to check her net worth regularly, to make sure that she stays on the right track!
How to evaluate net worth?
Some authors have published “guidelines” on how high your net worth “should be” based on your age, but to be honest, I don’t find these all too helpful. I’ve walked through one method from the classic book “The Millionaire Next Door” in this article, along with criticism on why I have not personally found that way of evaluating net worth beneficial.
Everyone’s situation is different, we all come from different circumstances and the country or even city that we live in can have a huge effect on what net worth is possible at which age.
Remember the quote from Theodore Roosevelt: Comparison is the thief of joy!
I think there is limited value in comparing yourself to others or to relatively arbitrary “standards”. Only you know your background and all the context necessary to decide if you consider your net worth to be good, bad, or somewhere in between.
If you ask me, the most important thing is that your net worth is growing over time, assuming that you are trying to accumulate wealth. That’s why I find it helpful to re-compute my net worth at least quarterly, to make sure that I am going in the right direction.
What if my net worth drops?
There are a few different situations that can cause your net worth to drop temporarily. This is not necessarily a cause for concern, unless it’s a lasting decline driven by bad habits.
Buying real estate for example often comes with significant closing costs, an expense that can temporarily lower your net worth. As real estate is generally considered an appreciating asset though, your net worth should recover over time.
Similarly, a stock market decline could hurt your net worth temporarily. Over time, the stock market would be expected to recover, so your net worth should go back up eventually as well.
Of course, once you retire and start living off your assets, you may also decide to draw down your wealth and therefore your net worth could decrease in retirement too.
All of these examples are usually not something to worry about. If your net worth drops temporarily due to an investment expense or a stock market decline, don’t panic. Especially for stocks or index funds, it’s important to remember that a decline is not a loss unless you sell when the price is low. Historically, it has usually paid off to hold stocks and funds through market declines and simply wait for the recovery.
However, if you discover that your net worth is decreasing over time because of your lavish spending habits, gambling, or other behaviour from which your net worth is not expected to recover, you may want to reconsider your choices.
What if my net worth is negative?
Having a negative net worth means that even if you sold everything that you own, you would not be able to pay back everything that you owe. Of course, that is not ideal, but it’s not a nightmare scenario either.
Importantly, having a negative net worth does not necessarily mean that you are bad at managing your finances.
Having a negative net worth can be quite common, especially for people who are at the beginning of their career. If you are a student or have only started working recently, you might have liabilities from student loans, but have not yet had a chance to build up sufficient assets to turn your net worth positive. That’s ok! Again, the important thing is that you keep an eye on your net worth and make sure that goes up over time.
So if your net worth is negative, don’t panic. It’s not the end of the world, not even close.
What it does mean though, is that you should probably focus on reducing your liabilities (pay off your debts) and/or building up your assets in order to turn your net worth positive and grow it over time!
I hope you found this article helpful! Please let me know in the comments if anything about the topic is still unclear. Also, let me know which concepts you want me to cover next!