What is your net worth? You’re probably scratching your head right now because you don’t know or you’re getting a pen and paper making your calculations because it’s a figure that you don’t normally remember. However, you should know what your net worth is and if you don’t understand the concept, it’s about time that you should. This is because your net worth will tell you if you are on track towards achieving financial health and wellness.
In simplest terms, your net worth is the result when you subtract the total of your debts and liabilities from your total assets. The difference can either positive or negative. Generally speaking, a positive figure is a good thing while a negative result tells you that you need to start looking into your finances more carefully.
Assets refer to the things you own. Examples of assets include your house, car, jewelry, paintings, appliances and gadgets. The cash in your savings account, the money you keep under your pillow and those you keep in the shoebox at the back of your closet—all these are your assets as well. Material things that you own which can be converted to cash are your assets so if you have a lot of possessions, you have a lot of assets.
Liabilities refer to anything that you owe. Your mortgage is a liability. Your car payment is a liability. The $50 you owe to your friend is a liability. Any outstanding balance on your credit card is a liability. Student loans, taxes and the like are also liabilities.
The process of computing your net worth is very easy. Here are the steps:
1. Determine what your assets are.
It’s very important to remember that the assets you should include in your calculation are those that you can sell. Collectibles, furniture, appliances and your car which is fully paid can count towards your assets in addition to the investments and savings you have.
2. Get the total for your outstanding debts.
From mortgage to loans to student loans to personal loans, include all these in your calculations.
3. Subtract your debts and other liabilities from your total assets.
The total is your net worth.
Your net worth will tell you a lot about the state of your finances. This is why you should know what your net worth is at any given year because you want to see it increase gradually. If it decreases, you should know the reason why and take steps towards correcting it. You can evaluate your budget, plug the leaks and craft a financial plan that will help you get back towards improving your net worth.
The significance of your net worth will depend if the result you get is a negative or a positive number. If it is positive, then you are on good footing. It means that you are already on the road towards building wealth. You have your debts under control and are most likely staying true to your budget. You are paying your bills on time and are contributing regularly to your retirement funds.
Since you already have established good spending and saving habits, all you need to do is just continue saving and investing. If you can, continue to ramp up your contributions so that your money will grow faster.
The challenge comes if your calculations arrive at a negative net worth. Now, take note that having a negative net worth is not necessarily a bad thing, especially if you are still young and earning so much less. However, this does not mean that you should just leave things be. A negative net worth signals that you should start doing something to straighten up your finances.
1. Start living on a budget.
The best place for you to start improving your net worth is by starting to live on a budget. Without a spending plan, your money will just go anywhere and you won’t be able to remember exactly where or how you spent it. Your budget is your blueprint. It will direct your spending. When you have a budget, you know where each dollar goes. Without it, you can’t expect to increase your net worth.
2. Start paying off your debts.
Debt is one of the things that can truly restrict you from improving your net worth. The interest rates are going to lessen the money you can otherwise put into your savings or your investments. Thus, you should craft a debt repayment plan and earnestly start paying down what you owe. You can concentrate on paying off debts with the highest interest first or you can begin with the one with the smallest balance so that you are encouraged with your progress. Whatever strategy you choose, pursue it with zeal and don’t stop until you have paid down every last penny.
3. Establish an emergency savings fund.
Improving your net worth is going to take time. However, there will be events along the way which could potentially derail your savings and investment goals because you will need to realign funds. To prevent this from happening, you should set up an emergency fund to take care of these unexpected expenses. Experts generally recommend setting aside three to six months’ worth of living expenses for your emergency savings fund. However, it’s better to set aside more if possible. When you have this cushion in place, you won’t be ruffled when major changes such as getting fired from a job challenge your savings goals.
4. Save, save, save.
Once you brought down your debt to manageable levels and have set up a rainy day fund, you can now concentrate on putting money to your savings account. Try to determine areas in your budget where you can cut down on costs and channel the money towards your savings.
Beef up your 401k or IRA contributions. By maximizing your annual contributions, you allow the power of compounding to work in your favor and your nest egg to grow.
5. Diversify your investments.
Diversification means not putting all your eggs in one basket. As far as investments are concerned, it means spreading them out across classes and industries so that your portfolio will be more able to ride out the fluctuations of the market without suffering too much damage. As far as your net worth is concerned, diversification is also important because you may have a high net worth but if most of these are tied to assets that cannot easily be sold when you need to then your assets are not also working for you.
If you find that most of your assets are tied to real estate properties that take too long to sell, for example, you can consider selling one of them so you can put the proceeds in savings account or certificates of deposit which are more liquid.
Your net worth is important not only as a measure of your financial health now but also as a way to gauge how ready you are to retire. When you include inflation into the equation, it becomes pretty obvious that the net worth you have now won’t be enough to sustain you when you retire thirty or forty years from now.
A simple rule of thumb to determine how much your net worth at retirement should be to allow you to live comfortably would be computing at least 10 times that your present income. Let’s say your annual household income before retirement is $50,000. Based on our very simplistic calculation, you would need to have a net worth of $500,000 by the time you retire so you can fund your golden years. If your net worth runs close to a million by the time you retire then you can pretty much rest easy since that would mean that you can finance your retirement.
Your net worth changes each year, especially if there are life events—marriage, childbirth, divorce, buying a home, selling a home—that would increase or decrease it. This is why you should monitor your net worth carefully and recalculate when there are major life events that could potentially make a major difference in it.
If you have a negative net worth, consider yourself lucky. It’s simply a wakeup call for you to start getting serious about your finances. Live on a budget, pay down debt, save and invest. If you feel that your current earnings will not allow you to do all these things, perhaps it’s time for you to start getting creative. Maybe you need an additional source of income, such as a part-time job on weekends, to help improve your cash flow. Remember that only by taking proactive action will you be able to see an improvement in your net worth.