Net worth: The most important number in personal finance?
Do you know your net worth?
Your net worth is a snapshot of your financial life at one moment in time, a single number representing your financial health. It's the total of everything you've earned and spent until today. In The Wall Street Journal Complete Personal Finance Guidebook, Jeff Opdyke writes:
Knowing your net worth is important…if only for one reason: It forces you to interact with your financial life, keeping you in touch with your money and knowledgeable about where you are on the road to where you think you're going.
Computing net worth is an academic exercise for some, with little impact on the way they deal with money. For others, it's a powerful motivator. In a guest post here last March, FrugalTrader described how his net worth went from $-40,000 to $285,000 in five years. He aims to increase this to $1 million by 2015. FrugalTrader's net worth guides his financial decisions.
Calculating Net Worth
Net worth is easy to calculate: It's simply the difference between your assets (the things you own) and your liabilities (the things you owe).
If, for example, you're just leaving home, you might have $2000 in the bank, but owe your cousin Harry $500. Your net worth would be $1500. On the other hand, if you only had $500 in the bank, but owed your cousin Harry $4000, your net worth would be -$3500.
In real life, the calculation can be more complex. Most people have a variety of assets and liabilities, some of which aren't straight-forward. (Exactly how much is your home worth, anyhow? That antique desk you inherited from your great-aunt Mabel?) If you need help listing your assets and liabilities, you can download a net worth worksheet [PDF] from The Quiet Millionaire.
Most personal finance software will compute your net worth, too. Quicken, for example, always shows my net worth (or what it believes to be my net worth) below my list of accounts. There are also many net worth calculators online.
Tracking Net Worth
After you've calculated your net worth, what can you do with it? Like FrugalTrader, you can use net worth to guide your future. Begin by tracking it systematically with a spreadsheet, or with a web-based tool like NetworthIQ.
Whichever method you choose to track your net worth, consider the following:
- Compute your net worth yearly. Changes to your net worth are only really meaningful over the long term. From month to month, a variety of factor can cause your net worth to fluctuate. An annual checkup is frequent enough to catch problems and to be sure you're still on course to meet your goals. (Quarterly checks would probably work, too.)
- Don't compare yourself to other individuals. It's fine to compare your net worth to other groups of people (all 30-35 year olds, for example), but it can be dangerous to begin comparing net worths with your friends. That can lead to lifestyle inflation, the need to “keep up with the Joneses”.
- Establish a system of measurement and stick to it. If you're married (or have a long-term partner), will you track your combined net worth, or just your own? What does that mean for shared possessions, like a house? And how do you measure the value of your home, anyhow? List what you paid for it? Take a guess as to the market value? Use the tax assessment? It matters less which answers you choose to these questions, and more that you choose the same answers from one year to the next.
According to The Federal Reserve Board's 2004 Survey of Consumer Finances [PDF], the median net worth for U.S. families is $93,100. If you dig through this survey, you can also find comparisons based on age, education, income, and more. (On average, college graduates earn nearly twice the income of high school graduates — and they have more than three times the net worth.)
Using Net Worth
“[Your net worth] is what you currently have to show for your lifetime income; the rest is memories and illusions,” write Joe Dominguez and Vicki Robin in the classic Your Money or Your Life. But they caution not to attach too much significance to the number: “Whatever you find, it's important to remember that net worth does not equal self worth.“
Net worth might not seem relevant if you're still working, but it will probably figure prominently in your retirement. Unless you can generate enough income from other sources (Social Security, pension plans), you'll eventually need to draw on the components of your net worth for living expenses.
That is, you'll need to sell that antique desk from great-aunt Mabel, or your sailboat, or even your home. All the parts of your net worth contribute to your total wealth.
Photo by David Hobby of the great photography blog, Strobist.
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