Net worth is your total assets minus your total liabilities. Changing your mindset from thinking about financial decisions in terms of “Can I make the monthly payments?” to “How will it affect my net worth?” can help you make wiser financial choices, and improve your financial health.
This post was inspired by my best friend Jillian who asked about how to start building wealth. One of the first steps is to start calculating your net worth.
To illustrate, let’s look at the following example:
Jane doesn’t have an exorbitant amount in credit cards, she has paid down most of her car payment, and has less than average student loan debt. She has been contributing to her retirement and has $1,000 in a starter emergency fund. She also recently purchased a home.
Jane sticks to her budget and can easily make all her payments. She thinks she is doing well! But is she building wealth?
Let’s take a look at her net worth.
- -$2,000 in credit card debt
- -$5,000 left on her car loan
- -$20,000 in student loan debt
- -$250,000 left in mortgage payments
- (a mortgage calculator will show that after interest, she will be paying more than $300,00 over the 30 year loan)
- let’s say she already has 2,000 in equity on her new home
- +$15,000 in retirement
- +$1,000 cash in the bank for emergencies
Total assets are $15,000 + $1,000 = $16,000
Total liabilities are $2,000 + $5,000 + $20,000 + ($250,000 – $2,000 equity = $248,000) = $275,000
- Therefore, her total net worth (assets minus liabilities) = -$259,000
Jane’s net worth is Negative. She owes $259,000 more than she has!
(Even if she didn’t purchase the home, her liabilities would still be more than her assets.)
Thinking about buying a new vehicle
Let’s say Jane is thinking about purchasing a new vehicle. She has 3 kids and trading in her sedan for a minivan will give them more room.
She found a great deal on a used minivan and the payments will be comparable to her current car payments. However, she only owes $5,000 on her current vehicle. The van will costs $20,000.
Can Jane afford to buy a van?
First, don’t confuse being able to take out a loan for something with being able to afford it. If she doesn’t have the money to pay cash, the answer is no, she cannot afford it.
If we’re thinking in terms of payments, yes, she can afford to trade in her vehicle for one with similar monthly payment (let’s say her payments are $400/mo).
However, rather than paying off her car within 1 year then snowballing that money to payoff her student loan debt, she will add an additional 38 months (3 years) of car payments!
If we are thinking in terms of net worth, if she buys another vehicle her net worth will decrease. Rather than having -$259,000 in net worth, borrowing an additional $15,000 will lower her net worth to -$274,000 in net worth (plus interest!)
Track your net worth
Trent Hamm had an article about this in The Simple Dollar. I use a simple excel spreadsheet to track my net worth every month.
What to include in your spreadsheet:
- Savings and Checking accounts
- Money Market accounts
- Employer-sponsored retirement plans
- Individual retirement plans (IRAs)
- Health savings accounts (HSAs)
- Non-retirement investments (e.g., stocks, bonds)
- Primary residence mortgage debt minus equity
- Investment real estate mortgage debt minus equity
- Student loan debt
- Car loan balance minus car value*
- Credit card balance
- Any other bank loans
- Personal loans (including money owed to family or friends – consider making paying this back a priority)
*Because vehicles (at least my vehicles) decline in value, I personally do not include them in my net worth. Now if I had a 1963 Corvette, then I might include it.
The value of each of these will likely change every month. Look to see how your net worth changes month to month and year to year.
When I am thinking about making a major financial decision, I will add those numbers into my excel sheet beforehand to see how it will affect my net worth. This has made me reconsider some choices (e.g., buying a van), and confirm my decision to make others (e.g., opening a Health Savings Account).
If you do not have an excel spreadsheet (or the time to make one), you can use a free online net worth calculator.
If you want to build wealth, then change your mindset from “can I afford the payment” to “how will this affect my net worth.” J.D. Roth (the founder of Get Rich Slowly) had a website called Money Boss in which he talked about managing your personal finances as you would a business. Thinking in terms of profits and losses is great advice for building personal wealth.
Make decisions that will increase your net worth. Even if you are starting out in the negative, get a plan to get yourself up to zero, then into the positive.
A consistent increase in your net worth is a sign of good financial health. It’s also a first step to building wealth.
Do you know what your net worth is? How has it changed from last year?