What is Net Worth?
When someone is said to be wealthy, this generally means that that person has a high net worth. It is the sum of all of your assets minus all of your liabilities. If you liquidated all of your possessions and paid off all of your debts the amount left over would be your net worth.
Owning a lot of material goods does not actually indicate a high net worth. In fact it could be just the opposite! If you buy a new $50,000 car by financing it, leaving you upside down due to depreciation on the car then you will actually have reduced your net worth.
If you have more debt than you have present value in your assets then your net worth is negative. This is a common situation among young adults as their student loan debt may outweigh any assets that they have been able to acquire by this point in their life.
Why is net worth important
You can calculate your net worth to determine your financial health. Once you have it, you can set goals of increasing it and track it over time. If it is increasing your wealth is increasing. Most common financial goals are attained by achieving a certain net worth.
You hear a lot of talk about retirement but your net worth is a much more fundamental and short term number to concentrate on. Retirement is only possible once a certain net worth is reached that allows you to maintain your lifestyle through old age. You could reach that number at any age or perhaps never reach it.
While the calculation is easy many people never bother to calculate it or track it. You should use a tool like Dollartrak App to easily determine it, see how your financial decisions might affect it, and keep up with your progress over time. You can even set goal goals and track your progress towards them.
Three rules for increasing your net worth
Increasing your net worth generally takes time but is simple to do. There are only really three rules:
- Acquire Appreciating Assets – Appreciating assets are generally considered investments. Examples of appreciating assets are stocks, bonds, real estate, CDs, and personal businesses. Appreciating assets create an upward pressure on your net worth.
- Avoid Liabilities – Taking on any debt immediately subtracts from your net worth. The interest costs on the debt also put downward pressure on it, eating up your income and preventing you from buying appreciating assets.
- Spend Less Than You Make – It is impossible become wealthy without learning to spend less than you earn. No matter what you income is, you can always spend more. You will never be able to generate any wealth if you are in a destructive pattern of overspending.
Applying the rules
You should steer clear of spending money on depreciating assets as they will go down in value over time. This creates a downward pressure on your net worth. You must make enough income every year to cover the depreciation of these assets in order to break even. It is not uncommon for a new car to depreciate over $10,000 in the first year alone!
You may notice that I did not mention your income. It is true that raising your income does give you more flexibility in purchasing appreciating assets. However, you can spend more than you make on depreciating assets no matter what your income is. It is important to learn to spend less than you make so that you can invest the difference no matter what your income is.
Keep opportunity cost in mind
Life is full of decisions and unless you are Jeff Bezos you only have so much money to spend. You should always keep the opportunity cost in mind when deciding on how to spend or invest money.
Most of the time making the decision is easy. Will spending $50,000 on a BMW or $30,000 on a Honda and investing the $20,000 be better for your net worth? What I specifically mean here is paying attention to competing investment options.
Assuming you opt for the Honda, that $20,000 can be invested in stocks, bonds, real estate, Bitcoin, a high yield savings account, etc. Make sure the return and risk of the investment fit your personal financial goals. Compounding interest is a very powerful force over long periods of time. Choose investments that advantage of it.
It is often overlooked but determining your net worth is one of the most important things you can do to understand your financial health. You should determine it and then keep up with how it changes over time. You should strive to put your net worth onto a trajectory of always increasing.
Once you understand this number and begin to learn how your decisions can affect it both negatively and positively, you will be in a position to begin to take total control of your financial situation.