Why knowing your net worth is important
By JEAN FOLGER
source from investopedia.com
Your net worth is the amount by which your assets exceed your liabilities. In simple terms, net worth is the difference between what you own and what you owe. If your assets exceed your liabilities, you have a positive net worth. Conversely, if your liabilities are greater than your assets, you have a negative net worth.
Your net worth provides a snapshot of your financial situation at this point in time. If you calculate your net worth today, you will see the end result of everything you’ve earned and everything you’ve spent up until right now. While this figure is helpful—for example, it can provide a wake-up call if you are completely off track, or a “job-well-done” confirmation, if you are doing well—tracking your net worth over time, offers a more meaningful view of your finances.
When calculated periodically, your net worth can be viewed as a financial report card that allows you to evaluate your current financial status and can help you figure out what you need to do in order to reach your financial goals.
Your assets are anything of value that you own that can be converted into cash. Examples include investments, bank and brokerage accounts, retirement funds, real estate and personal property (vehicles, jewelry, and collectables)—and, of course, cash itself. Intangibles such as your personal network are sometimes considered assets as well. Your liabilities, on the other hand, represent your debts, such as loans, mortgages, credit card debt, medical bills, and student loans. The difference between the total value of your assets and liabilities is your net worth.
One of the challenges in calculating your net worth is assigning accurate values to all of your assets. It’s important to make conservative estimates when placing value on certain assets in order to avoid inflating your net worth (i.e., having an unrealistic view of your wealth). Your home, for example, is probably your most valuable asset and can have a significant impact on your financial situation. Determining an accurate value of your home—by comparing it to similar homes in your area that have recently been sold or by consulting with a qualified real estate professional—can help you calculate realistic net worth.
Notably, however, there is some debate about whether personal residences should be considered assets for the purpose of calculating net worth. Some financial experts believe that the equity in your home and the market value of your home should be considered assets because these values can be converted to cash in the event of a sale.
That said, other experts feel that even if the homeowner did receive cash from the sale of the home, that cash would have to go toward the purchase or rental of another home. This essentially means that the cash received becomes a new liability—the cost of replacement housing. Of course, if the home being sold has more value than the replacement residence, part of the former home’s value can be considered an asset.
What does it mean?
Your net worth can tell you many things. If the figure is negative, it means you owe more than you own. If the number is positive, you own more than you owe. For example, if your assets equal $200,000 and your liabilities are $100,000, you will have a positive net worth of $100,000 ($200,000 – $100,000 = $100,000). Conversely, if your assets equal $100,000 and your liabilities are $200,000, you will have a negative net worth of minus $100,000 ($100,000 – $200,000 = -$100,000). Negative net worth does not necessarily indicate that you are financially irresponsible; it just means that—right now—you have more liabilities than assets.
Like the stock market, your net worth will fluctuate. However, also like the stock market, it is the overall trend that is important. Ideally, your net worth continues to grow as you age—as you pay down debt, build equity in your home, acquire more assets, and so forth. At some point, it is normal for your net worth to fall, as you begin to tap into your savings and investments for retirement income.
Why your net worth is important
When you see financial trends in black and white on your net worth statements, you are forced to confront the realities of where you stand financially. Reviewing your net worth statements over time can help you determine 1) where you are, and 2) how to get where you want to be. This can give you encouragement when you are heading in the right direction (i.e., reducing debt while increasing assets) and provide a wake-up call if you are not on track. Getting on track may include the following:
Knowing your net worth is important because it can help you identify areas where you spend too much money. Just because you can afford something doesn’t mean you have to buy it. To keep debt from accumulating unnecessarily, consider if something is a need or a want before you make a purchase. To reduce unnecessary spending and debt, your needs should represent the majority of spending. (Keep in mind that you can falsely rationalize a want as a need. That $500 pair of shoes does fulfil a need for footwear, but a less expensive pair may do just fine and keep you headed in the right financial direction).
Pay down debt
Reviewing your assets and liabilities can help you develop a plan for paying down debt. For instance, you might be earning 1% interest in a money market account while paying off credit card debt at 12% interest. You may find that using cash to pay off credit card debt makes sense in the long run. When in doubt, crunch the numbers to see if it makes financial sense to pay down a certain debt, taking into consideration the impact of no longer having access to that cash (which you might need for emergencies).
Save and invest
Your net worth figures can motivate you to save and invest money. If your net worth statement shows that you are on track to meet your financial goals, it can encourage you to continue what you’re doing. Conversely, if your net worth indicates room for improvement (for example, over time you have dwindling assets and burgeoning liabilities), it can provide a needed spark of motivation to take a more aggressive approach to save and invest your money.
What is the difference between net income and net worth?
You earn income if you either work for someone or run a business. Your net income is your income after taxes and payroll deductions, such as social security and money you contribute to your pension. This is different from your net worth, which is the total value of everything you own, minus all your debts.
How often should I calculate my net worth?
There is no one set rule on how often. For some people, calculating net worth quarterly makes sense, while for others, a yearly calculation is best. Some advisors suggest you also recalculate after a large purchase or sale, like a house or car.
What does liquid net worth mean?
Liquid net worth is the portion of your net worth that could be easily converted to cash in a day if need be, versus an asset that would take some time to convert, such as jewellery or property.