Calculating your Net Worth is essential to getting ahead, financially. This simple calculation yields all sorts of insights into your finances.
I have noted before that if you want to get ahead, in terms of accumulating wealth, it pays to calculate your Net Worth on a regular basis - at least annually, if not more often. This calculation can show you how well you are really doing, in terms of building up your estate.
Most folks, including myself, until I was about 30, figure that if their salary is going up over time, they must be doing well. And if the balance in their 401(k) is increasing, things are good. But we fail to look at the overall picture - assets minus debts - and understand where we really are.
Because most folks also increase their debt load over time - taking on bigger mortgages, larger car loans, increased credit card debt, and consumer loans for jet skis and crap. While they are making more and more money and the balance in their 401(k) is going up (from $50,000 to $55,000 - whoowhee!) they fail to understand that their Net Worth may actually be declining.
Calculating Net Worth is not hard to do. You can use a spreadsheet, or even just a document in WORD (which I do, using their TABLE function), or even on a yellow legal pad, with a pencil.
First, add up the value of all your investments and savings in two categories, pre-tax and after-tax. After-tax investments are things like savings accounts and other money you put aside for a rainy day. Pre-tax investments are things like your 401(k) or IRA, that you have not paid tax on.
Generally, people say you should have enough after-tax investments to live on, for six months. Most people don't have this much money, which is scary. Cutting your monthly expenses is one way to make a small amount of savings last that vaunted six months. If you "need" $100,000 a year just to pay the bills, you'd better have $50,000 in after-tax savings. On the other hand, if you can learn to live on $50,000 a year, well, you don't need nearly as much - only about $25,000 or so. If your "six month emergency fund" is a little low, one way to bring it up to snuff is just to cut out expenses in your life - like Cable TV, smart phones and other junk.
As for your pre-tax investments, there are other rules of thumb. Some say you should have a year's salary saved up by age 30. That is a good rule. If you want to retire in any range of comfort at all, you'd better be on track to have $500,000 to $1,000,000 in savings by retirement time, at least as of the time of this writing. Using the 4% Rule for withdrawals, this amounts to only $20,000 to $40,000 in retirement income, which along with Social Security, might provide you with a modest middle-class existence in retirement. If you want to vote for a candidate who promises to cut your benefits and subject you to a "means test" you might want to save more.
Next, add in the value of the physical assets you own. Many financial advisers frown on this, arguing that your principal residence should not be counted as part of your "Net Worth" - nor should your cars, furniture, computers, etc. But they are part of your Estate, and if you died tomorrow, these things would be sold and the amount realized added to your bottom line.
And it is also illustrative to do this, as it points out why spending money on "things" is fruitless. While you may have spend $100,000 on all the junk around your house (computers, furniture, clothing, electronics, appliances, etc.) chances are, this stuff is worth maybe $20,000 in liquidation value. "Things" depreciate in value rather quickly, the moment you buy them. As a result, the more "stuff" you buy, the poorer you will be. And yet, most Americans equate owning a lot of "stuff" as a sign of wealth. It is the opposite.
This may be the most relevant thing you learn from calculating your Net Worth.
And by the way, it is tempting to lie to yourself at this point, putting down inflated values for your home, your cars, and your pile 'o crap in your house. "I saw a car like mine for sale at a dealership for $20,000, so mine must be worth that much, too!" Wrong Answer. Use the book value, for trade-in or private party sale, that is a more realistic assessment of the worth of your vehicles. Similarly, using asking prices for houses in your neighborhood is just being silly. Sales prices are going to be closer to actual value - and be ruthless in evaluating the condition of your house.
As for the other stuff? Chances are, used electronics are worth little or nothing - a few dollars at most - and they decrease in value every year. That new iPhone is worth a few hundred on eBay. In five years, it will be worth $50, if that. Those designer clothes from Abercrombie & Hollister are worth pennies in a thrift shop, particularly when they are out-of-style next year. A $50 t-shirt is worth a buck or two at most, at a garage sale. So don't delude yourself by assigning inflated values to your "chattel" - exercises in self-delusion are rarely informative.
Another observation you may take away from this is that a lot of stuff can be had very cheaply, used, at a garage sale or thrift store. It is worth at least a look.
Finally, start adding up the debts - and use the real numbers, not the rounded-off numbers in your head. It is not hard to go online and get the exact balance on your mortgage, to the penny, in real time. Ditto for your credit cards, car loans, student loans, etc. Then, take the assets and subtract the debts - this is your Net Worth. The overall number you come up with may scare you.
In fact, it may be a negative number. And if you had been doing this calculation for a number of years, you would have noticed it was negative and getting moreso over time. This is not an atypical thing to happen to most Americans, particularly these days.
If your Net Worth is positive, good for you. But by how much? If you are 40 years old and have a Net Worth of $100,000, you should think long and hard about how you are going to afford retirement. And please don't say, "Well, I'll work until I'm 70" because that might not work out.
There is one other observation to take away from this Net Worth calculation. Look at how dependent your Net Worth is on a number of factors outside of your control. You have a fat balance in your 401(k), for example - but that depends a lot on market values of your mutual funds. As we all learned in the waning days of the Bush Administration, that can drop in value by half in a real hurry.
Similarly, home values can vary, particularly if they are overpriced. And when I did this calculation back in 2007 (I have been doing this since 1990, and have a thick binder of printouts, which I have charted over time) it scared the crap out of me. My Net Worth, on paper was very good, but I had a lot of debt, which was offset by the inflated values of the Real Estate I owned. If the value of my Real Estate dropped suddenly, I would be wiped out - owing more in loans than I had assets to cover - the technical definition of Bankruptcy.
In other words, I was highly leveraged with debt, which is never a comfortable place to be.
So I got out of the Real Estate market. I only wish I had sold out of the stock market as well, but timing the Stock Market is very hard to do. I also got out of debt. It was the one sure number I could change on my Net Worth Chart that would never vary in value, once I changed it. Stocks may go up and down in value. Housing prices can vary all over the place. The value of my cars and chattel will decrease over time - that is a given. But debt paid-off is always paid-off. It is a savings more guaranteed that government bonds.
So what insights do I take away from this calculation?
1. It is essential to calculate your Net Worth regularly to see where your overall financial situation is headed. Not knowing your basic Net Worth is like going out to sea without a compass.This is not to say you should take dramatic action to get out of debt - for example, by not funding your 401(k) or something. No, rather, what I mean is that you should have a plan to eventually be debt-free, before you are retired, preferably a decade before you are retired, if possible.
2. Physical Assets such as cars and personal possessions decrease dramatically in value over time, thus it pays to buy less "stuff" in your life, or to buy things that will last you a long time (e.g., a well-made suit, rather than Chess King clothing).
3. Valuation of assets, including Stocks and Real Estate can change over time - values are not guaranteed. If you own a lot of assets and have a lot of debt, you are leveraged, and thus at the mercy of these valuations. If valuations go down, you can be insolvent in a heartbeat.
4. Paying off debt removes this lever, and guarantees an increase in your net worth. Increasing debt load over time, as you make more money, just places your Net Worth in stasis.
Oddly enough, I meet a lot of people - most people - who have not done this calculation. Many older folks live the "cash flow" lifestyle, basing their economic well-being on how much money comes in every month, and how much they have to pay in "bills" for monthly living. So long as their income is higher than their "bills" they assume they are fiscally sound.
And for our older generation, who bought everything "on time" and was assured a defined-benefit pension in retirement, maybe that made sense. They got a steady paycheck from the big company for 30 years, and now they get a steady retirement check until they die.
For them, living the cash-flow lifestyle might have made some "sense" or at least, it was survivable. But for our generation, who needs to survive on their savings, it is simply not an option. We have to live off our Net Worth, not our Income.
Calculate your Net Worth, and do it often. See where you are headed, financially. It is your financial GPS, telling you where you are, and where you are headed, and whether you are headed for safe harbor, or for the rocks.