Many judge wealth on how much income someone makes. Though income is important, it is only part of the story. Wealth is better defined as what you keep, rather than what you spend.
What is Net Worth?
Net Worth is a measuring tool for determining the value of a person, business, institution, or other groups. In simple terms, Net Worth = Assets – Liabilities. Assets being everything that you own (home equity, 401k, checking account balance, etc.) that has monetary value, and liabilities are all the debts or obligations you owe to someone else (mortgage, car payments credit card debt, etc.).
To better illustrate this topic, let’s take a look at an example:
Jeff and Tom both live in the same town but live two different lifestyles. Jeff is a well-to-do lawyer who owns his own practice pulling in an after-tax $190,000 salary. Tom is the town engineer making a $60,000 salary after taxes. Two very respectable careers that are earning varied salaries.
Jeff has worked hard to get through law school and build his practice. He feels that it is important to keep up appearances to attract more clients and deserves to spend his hard-earned money. Jeff went ahead and took out a mortgage on a 4,000 sqft house, leases a BMW M6, frequently purchases designer clothes, and eats out frequently. It ends up costing Jeff $187,000 a year to keep up this lifestyle.
Tom has a different mindset. Tom does not have to impress clients and prefers to spend his time keeping up his home, going on hikes with his dog, and experimenting with different dinner recipes. Tom lives in a modest home at 1,800 sqft, drives a used Subaru that he purchased outright, and is more frugal with his spending. For Tom to live this lifestyle he spends $40,000 a year.
Now, who is wealthier out of the two? At first glance, many would assume Jeff. After all, he lives in the big house and drives the Beamer. Remembering our first statement, wealth is defined on what you keep, rather than what you spend, Tom has accumulated more wealth over the year than Jeff.
Since Jeff is highly leveraged and using debt to fund his large house and a fancy car he has a high number of liabilities. He may even have more liabilities than assets causing him to have a negative Net Worth. We know Tom has saved $20,000 this year and is not overloaded on liabilities. Tom likely has a higher Net Worth than Jeff making him the wealthier individual.
Why is it important?
We all know the saying “Money Can’t Buy Happiness”. What it can buy though is time and peace of mind. A 2017 study “Buying Time Promotes Happiness” published by the National Academy of Sciences showed that spending money to buy time-saving services was linked to greater life satisfaction. Having control over what individuals could do with their time showed greater happiness than material purchases.
The wealthier someone is, the more time they can purchase. If you have 6 months of emergency funds stashed away and lose your job, you are not in a position where you would have to take the next gig that comes across your desk. You can take your time and find a job that you can enjoy. If your net worth was closer to $2,000,000 you may not even have to go back to work at all.
Having a higher Net Worth relative to your expenses enables you to be flexible with your life. This is the real important part of your Net Worth. Not to brag about how much money you have in the bank.
Liquid Net Worth
Going a step further, Liquid Net Worth gives the best idea of your total purchasing power at any given moment. The “Liquid” portion of your net worth is the sum of your assets and liabilities that are easily converted into cash. Examples of liquid assets are stocks, cash, and most financial assets one would have. On the liabilities portion, this would still include all loans or money owed.
If a surprise bill comes along and having to sell your home to pay it is not very practical. Where would you live? Excluding assets like your home give you a better understanding of how you would be able to handle a financial “hiccup”.
In my opinion, your Liquid Net Worth is the best indicator of financial health. Not only does it show how well you can handle surprise expenses, but the ability to act on investment or general life opportunities. Have you found a home in your town that is severely undervalued? You can go ahead and make the purchase. Need some time away? You can go ahead and book the flight to Honolulu.
How to Calculate Your Own Net Worth
Calculating your Net Worth is simple once you can get all your information together. You will want to find out the value of all your assets first.
A person’s main assets are likely to be the equity in their home, any retirement accounts (401k, IRA), cash in the bank, and any other investment accounts that they may have.
On the liability side, this would include the sum of their credit card debt, auto loans, mortgage, and any other personal loans that are outstanding.
Let’s take a look at an example of Net Worth for Tom who we talked about earlier in the article:
- Tom’s Assets:
- Home Equity: $100,000
- 401k: $250,000
- Bank Accounts: $10,000
- Brokerage Account: $30,000
- Tom’s Liabilities:
- Mortgage: $150,000
- Credit Card Debt: $1,500
- Personal Loan: $10,000
- Auto Loan: No Balance
- Tom’s Net Worth:
- Total Assets: $390,000
- Total Liabilities: $161,500
- Net Worth = $228,500
Notice that I did not include many other items that Tom may own into his Net Worth. Adding in depreciating assets (items that decrease in value over time) will give you a false sense of your total wealth. Since these items decrease in value, you may look at your Net Worth today with an idea that you’re financially secure when you are setting yourself up to lower your future wealth. I prefer to leave out cars, electronics, or any other valuable material items.
Another way to look at Net Worth is your Liquid Net Worth as previously explained. Let’s take a look at Tom’s Liquid Net Worth:
- Tom’s Liquid Net Worth:
- Total Liquid Assets: $290,000 (Notice we left out the home equity)
- Total Liabilities: $161,500
- Liquid Net Worth: $128,500
Tom’s Liquid Net Worth includes all of the liabilities as his original Net Worth but excluded the equity in his home.
Well, there you have it, everything you need to know about why Net Worth is important. I have created a basic Net Worth calculator here that you can use to calculate your Net Worth similarly to how I calculated Tom’s. More articles to follow on ways to build up your Net Worth!
