Your net worth, simply put, is the difference between the value of what you own (assets) and what you owe (your liabilities). If your assets are greater than your liabilities, then your net worth is a positive number. However, if your liabilities exceed your assets, your net worth is a negative number. This number gives you a quick picture of your financial status at a particular moment in time.
Knowing just your income and savings alone cannot give you a clear enough picture of your financial state to help you make important decisions about spending and saving. Moreover, it can be hard to make and meet goals when you do not know where you are starting out. Despite this, many people avoid figuring out their net worth because they believe it is too difficult, time-consuming or yields a result they do not want to face. Fortunately, calculating your net worth is actually quite easy and can actually serve to empower.
Why Calculating Your Net Worth is Important
Your net worth can give you a wake-up call if your finances are in dangerous disarray or give you confidence and peace of mind about your ability to make ends meet and even pursue goals. It can also give you a valuable perspective on your finances as you move forward in life. Your net worth indicates the condition of your present financial health and aids in determining how to go about meeting your monetary objectives.
If your net worth is a negative number, then you know you must either earn more, save more or reduce some of your liabilities to make it positive again. If your net worth is a positive number, on the other hand, then you know you have a starting point from which to start building toward your goals. You also know how much you can spend in the moment without tipping the scales and turning your net worth negative.
How to Calculate Your Net Worth
To figure out your net worth, you first need to identify your assets and your liabilities. The most obvious of your assets is the cash you have on hand and in savings, but cash is far from your only asset. Your assets also include all the things you own of value which you can convert to cash if need be. Examples of assets include some of the following:
- Bank accounts
- Brokerage accounts
- Retirement funds
- Personal property like jewelry, collectibles and vehicles
- Real estate
Some people also factor in personal networks and other intangible elements when tallying their assets. Your liabilities are all your debts. These may include some of the following:
- Credit card debt
- Student loans
- Medical bills
- Personal loans
To calculate your net worth, just add up all your assets and all your liabilities and subtract the former from the latter. Your liabilities minus your assets yields a positive or negative number that represents your net worth at the time. Some people use a simpler method to gauge a rough estimate of their net worth. They subtract 25 years from their age, even if it yields a negative number, and, then, multiply that number by the result of dividing their gross annual income by five. In other words:
[Gross Annual Income / 5] x [Age – 25] = Net Worth
Challenges in Calculating Net Worth
While it can seem be simple enough to calculate your net worth, there are certain challenges that can make determining your net worth more difficult. One such challenge is determining the accurate value of all your non-cash assets. You do not want to overvalue your assets, lest you come up with an inflated version of your actual net worth. To avoid this unrealistic picture of your financial status, use more conservative estimates of your assets’ value.
For example, for many people, their home is their most valuable asset. Determining the value of your home can be a challenge, however. The price you paid for the home can be an inaccurate figure for the home’s actual value, if it has depreciated over time or you have paid down much of your mortgage or done major improvements and renovations. Getting a professional appraisal is one way to determine your home’s present value, but that costs money too. Even then, you still must decide whether the replacement cost or comparable sales price is a more accurate representation of its value.
Furthermore, if you still owe money on a mortgage for that home, then neither the replacement cost nor the comparable sales price truly represents the value of that asset. In truth, only the equity in the home, or its appraised value minus the amount still owed on the home, represents its value to you as an asset. When the home sells, the remaining balance on your mortgage and all other liens on the home are paid off from the proceeds before you see any of that cash. Moreover, you still need a place to live after selling your home, so much of those cash assets you just received from the sale must go toward your future residence. In essence, replacing the home you just sold becomes a new line item on the liability side of the net worth equation.
As this example shows, your net worth changes constantly. If you own stocks, their value fluctuates regularly. If you own a car, its value is always depreciating unless you put money into it. To make it even more confusing, money spent on an education can be an asset by one rationale and a liability by another. The trick is to always plug in actual figures and not potential figures. For example, you may be able to earn more in the future with the education you are getting now, but the money you pay in tuition is money spent that you cannot recover. Therefore, it is not quite an asset yet.
Related Article: Evaluating Your Assets