Understanding Net Worth
- January 9, 2018
- by Michael
Net worth is a way of measuring your progress towards financial goals. It is calculated by adding up the net market value of your assets and subtracting all your debts.
Why Net Worth Matters
Unless you live in a non-capitalistic country, a higher net worth is better. A larger net worth translates into more options in life, access to better things, new experiences, and a safer retirement. As net worth increase it gets easier to make it grow because the money you've saved is working for you.
A large net worth can become a problem in terms of correctly managing it, keeping it safe, and not letting it go to your head. We hope that the tools and resources at Wealth Meta will be of use to you in building your net worth and solving the "problem" of keeping an eye on it and managing it correctly.
If you want to build net worth - it is about what you keep, not what you spend.
How much Net Worth Is Enough?
A common net worth target for retirement is approximately 25 times expenses (minus any income from pensions or social security, and not counting the value of your primary residence). The 25 factor comes from a safe withdrawal rate of about 4% - see this calculator for details and our related article How Much Is Enough for Retirement?
If you are interested in hitting a certain net worth target, you can see if you are on track with our Income and Spending Simulator.
What Kind of People Have a High Net Worth?
By looking at someone you might be able to guess their net worth, but appearances can be deceiving. Just because some one owns a nice car, lives in a big house and has a fancy title doesn't mean they know how to manage their money. More likely they are just really great at spending and carry lots of debt. High spenders may end up broke in retirement unless they have an inheritance coming or a hard working spouse to keep them afloat.
A famous book The Millionaire Next Door talks about the kinds of people who have a high net worth. Surprisingly people with high net worths are pretty boring - they work steady jobs, drive older cars, and do their own landscaping. Contrast that with the person who renews their Porsche lease every 2 years (had to get the Turbo) and buys lots of cutting edge electronics there isn't even content for yet (I'm look at 4K TVs). Everybody has their own priorities but you can't spend all your money on shiny stuff and build your net worth at the same time.
Your Net Worth Should be Kept Private
Even though capitalistic societies use net worth to keep score, most people don't share their net worth publicly. In fact it would be stupid to because it makes you a target. Another reason not to talk about it is a lot people are uncomfortable with the subject (due to ignorance, bad decisions, or emotional hangups learned from childhood).
Let's look at computing Net Worth in a little more detail...
Net worth is the value of your assets minus your debts. Net worth does not take into account income. Nor does it take into account retirement benefits like social security or pensions that pay out on a monthly basis. Net Worth does does take into account everything you own including: house, car, marble collection, bank accounts, retirement accounts.
Net Worth = Total Assets - Total Debts
If your debts are greater than your assets, your net worth will be negative. Yes a negative net worth is possible, and unfortunately pretty common for a newly minted college graduate.
What’s an Asset?
Even though the idea behind net worth is incredibly simple, as is the actual calculation, the most important part of determining your net worth is correctly determining what should (and should not) be counted as an asset.
An asset is really anything that is either cash or has a real value, ie you could convert it to cash if need be.
For the purposes of valuing an asset in a net worth calculation use the net market value. That means after the deal is done, what you have left in your hand is what it is worth. Think of it as the liquidation value (what you’d get if you were converting everything you own to cash by selling all your possessions at a reasonable price). Net market value is typically a lot less than you paid for it, and gets tricky with things like houses because of closing costs and selling fees.
Money in the Bank
Cash is the simplest. If you have $2,000 in your checking account and $7,000 in your saving account, you have $9,000 in assets right there.
You should also count the current value of any investment accounts. This can include stocks, ETFs, mutual funds, individual bonds, CDs and any other investments you have. Keep in mind the value of investments can fluctuate. For a person with a net worth of $500k invested in stocks a 2% change in the market equates to a $10k change in net worth.
For most people, this means their home. If you own your home (or any other property), you should count it as an asset when you calculate net worth. Try to get a realistic idea of the property’s real market value and include that number as an asset.
You should also include rental property, vacant land, vacation homes… any type of property that you could potentially sell. Just be conservative with what you can get for it. Sure Zillow might say your house is worth $500k... But you won’t clear that much since even if you are offered $500k what you get will be reduced by closing costs, seller’s fees, taxes, etc. Those typically add up to about 10% of the sale price, yikes!
Vehicles are also assets—just remember that unlike real estate, they tend to depreciate. Whether you have a year-old Tesla X or a 20-year-old Buick, find out what the real market value for the car is on a site like Kelley Blue Book and put that into your asset column. Some people don't worry about including their vehicles in their net worth since they are more of an expense than an investment. Personally I don't count vehicles in my investable net worth (which I'm targeting for retirement), but I do have them in my total net worth (which is only for fun).
Jewelry, Collections, Heirlooms, and other Stuff
If you have other items that you think have value, it’s fair to include them in the net worth calculation. This could be jewelry, a baseball card collection or antique furniture. However, remember that what matters is not how much you paid for the item, but how much you could sell it for. The "insurance value" or "sentimental" value of an heirloom is likely a lot more than what you’d get at auction tomorrow. Jewelry generally depreciates dramatically, while in some cases a baseball card collection could be worth thousands (I personally know someone who, during a period of unemployment, sold his baseball cards on Ebay and earned more per month than his wife, who was working full-time).
When you’re evaluating whether or not your stuff is really an asset, you mostly just need to be honest with yourself.
Those stock options you are vesting in at work are not an asset!
I don't care that the series B valued them at $100,000. I know your boss said "they will be worth millions". Chances are you can’t sell them until the company goes public. So they are not liquid. Not to mention you are vesting so if you quit (or get fired or laid off), you lose most of them. Also keep in mind to get to the famed IPO a lot of people need a cut. Those people are likely way more powerful and important than you. So your shares are subject to dilution too. The actual value of those shares is fluff used by HR to recruit for a “fast paced environment”.
What’s a Debt?
This is easy. If you owe it, it’s a debt. Every kind of debt should be counted. Here are some common types of debt people consider in their net worth calculation:
- Student loans
- Car loans
- Credit cards
- Medical bills
- The $200 you owe your brother/friend/parents
- Back taxes / tax liens
Net worth is a good snapshot of your financial health, and it’s relatively simple to calculate. The key ingredient in determining your net worth is honesty—even if your financial picture is sobering, you need to be honest with yourself about all of your debts and the real value of all of your assets.