Everyone likes to keep score. For most of us, when we keep score, we try to focus on improving it, whether it’s improving our golf game, losing weight, or building our net worth. We like to know where we stand – in relation to our goals and everyone else. The problem is most people don’t start focusing on their net worth until they have retirement in their sights. However, as a key indicator of your personal financial health, not knowing at any time whether your net worth is improving, declining or stagnating, and the reasons why, could lead to bad decisions along the way. And, it’s tough to turn the game around when the clock is running out.
Of course, there are others way to keep score financially. Many people, especially younger adults, base their financial progress on their income. To them, their net worth may not seem to be a meaningful measure of their success, either because they have little or they are more focused on consumption than savings, or both. Plus, income is the way people can gauge their success in comparison to others, even though it has little to do with their overall financial health. You have probably heard of high earning athletes and entertainers declaring bankruptcy and wonder how that is even possible.
It’s really quite simple. When people don’t have a clear vision of their future, they tend to focus on the present and take their cues from the people around them. If they don’t have a purpose for their money, the natural tendency is to succumb to the pursuit of more, assuming that an incremental upgrade in their lifestyle will somehow make them happier. However, people who have a clear vision of their future tend to view wealth as a means to an end. For them, their net worth represents an important scorecard of their accomplishments.
At its simplest, your net worth is the difference between your assets (everything you own) and liabilities (everything you owe). Mathematically, it looks like this:
Totals Assets – Total Liabilities = Net Worth
So, if you have $350,000 in total assets and $200,000 in total liabilities, your net worth is $150,000.
Calculating net worth is simple arithmetic – you just need to make sure you’ve correctly identified all the components. For instance, your vehicle is an asset but, if you have a loan on it, you also have a liability. Same with your house. You simply need to make sure each component is properly identified.
First, you list all your assets that have value and can be converted into cash.
Next, list all your liabilities (debts).
After totaling each list subtract your liabilities from your assets to arrive at your net worth. While it’s entirely possible for the number to be negative, just remember, it is merely a snapshot in time. Regardless of the size of the number, if you use it to keep score, from now on you can focus on the things that will make it grow over time.
You can either work on ways to grow your assets or find ways to lower your debt, or some combination of both.
It’s the most precise measure of your financial health. When tracking your financial progress, the numbers tell the tale and, there’s nothing more telling than your net worth. Like your blood pressure and other vital signs, it needs to be tracked periodically at regular intervals because it provides an indication of whether you’re getting better, getting worse or staying the same. If you’re losing value, it enables you to diagnose the problem (i.e. a growing credit card balance), so you can make the necessary course changes. Your goal is to have your net worth grow each year.
It keeps you focused on vital issues. As a true measure of your wealth, your net worth keeps you focused on what is important in growing it. Your income is important, but it’s what’s left after all your spending that goes to the bottom line of your net worth that counts. The value of your assets is important, but it ignores the amount of debt you’re carrying. The size of either your assets or debt doesn’t matter – only the difference between them. There are really only two issues you need to focus on – increasing your assets and reducing your debt. Either will improve your financial health.
Banks want to know. If you are not already relying on bank financing for a mortgage or loan, you most likely will. Since net worth is the best measure of your financial strength, it’s of particular interest to lenders. It can be especially important if you want to refinance a mortgage in retirement to improve your cash flow. Without earned income, your net worth becomes a key factor in determining your loan worthiness.
Achieving your retirement ambitions. If your ambition is to live a good life the rest of your life, the size of your 401(k) plan isn’t what matters most. While it’s important to grow your retirement nest egg as much as possible, if it’s sitting on a layer of debt, it may not last as long as you need. Knowing your net worth today and tracking it every year gives you a clearer picture of your progress towards your retirement goal.
When setting a critical goal such as retirement, it helps to establish savings benchmarks that can be tracked along the way. However, if you don’t track your net worth, you could lose sight of the actual amount of capital that will be available. While it’s not necessarily a bad thing to carry debt into retirement, it’s important to know how it will affect your net cash flow. As part of your retirement plan, it would be important to include a strategy to pay down your debt as much as possible.
There are a lot of things that can negatively impact your net worth such as buying a home, a temporary stock market correction; a medical emergency. Young professionals carrying a big load of student debt may not see a positive net worth for many years. It’s important to remember that your net worth is just a snapshot of your financial picture. It will change over time. It’s also important to remember that nearly every financial decision you make going forward will move the needle – either forward or backward. Perhaps, when viewed through that lens, you can frame every decision with “how will this affect my net worth?”