Calculating your net worth is one of the most important things you can do to jumpstart your personal finances!
Through financial coaching, this is one of my biggest goals for you.
How can you avoid money myths and align your habits so that your net worth is increasing every month?
Let’s dive into understanding your net worth, why net worth is important, and how to increase your net worth.
What is net worth?
Before learning how to increase your net worth, you must first understand what is net worth.
In its simplest form, net worth is how much you are worth as a person if you sold everything of value to you.
Think of it as the overall value of yourself and the things you own.
In finance, there is something referred to as a balance sheet, which I’ll explain more below. This is essentially the same thing as net worth.
Your net worth (and your balance sheet) say that everything you own (your assets) is made up of money that you borrowed (your liabilities) and/or the portion you own (your equity).
Look at one individual asset as an example.
When you purchase your house (the asset) it is made up of a mortgage (the liability) and your equity (down payment).
As you make payments on the mortgage, the liability balance goes down and the equity balance goes up.
When the market rate of your house goes up (the asset), your equity goes up.
If you owe more money than the value of your assets, then you have a negative net worth. Yes, you can have a negative net worth. This is why focusing on net worth is so important when evaluating your financial situation.
Now expand this to your entire financial situation.
Let’s take a look at what are financial assets and financial liabilities that make up your net worth.
How net worth of a person is calculated
As mentioned above, the balance sheet is the most important financial statement that shows your financial stability. When calculating the net worth of a person, it equates to financial freedom.
Balance sheet formula:
Assets = Liabilities + Equity
In layman terms, what you own (assets) is made of money borrowed (liabilities) and money paid (equity).
By rearranging the order of the balance sheet equation, we get the net worth equation.
Equity (net worth) = Assets – Liabilities
This is how the net worth of a person is calculated. Therefore, to increase your net worth, accumulate more assets and lower your liabilities. This equation will give you the overall value or net worth of yourself.
What are financial assets?
Your financial assets are things like cash, brokerage accounts, 401(k)s, HSAs, IRAs, real estate, jewelry, hard assets, cars, etc.
Anything of value can be considered an asset (I wouldn’t include things like clothes, TVs, furniture, or any other household items). These items often lose value immediately and are not how to increase your net worth.
But I would include loans on household items…and this is why it’s a bad idea to finance these financial liabilities.
Your income is not a financial asset and does not go on your net worth statement. It goes on your profit and loss statement.
What are financial liabilities?
Your financial liabilities are money that you owe to any company or person.
Common liabilities are credit cards, student loans, car loans, personal loans, mortgages, 401(k) loans, family loans, etc.
A common misconception is that the liability is the monthly payment amount. It’s not. It is the entire amount of the loan that you currently owe.
For example, say you borrowed $50,000 to buy a car last year. This year, the auto loan is $46,000 after making a year of payments. Your monthly payment is $500.
Your liability at the time of preparing your net worth statement is $46,000, the total amount owed as of today.
It is not the monthly payment. The monthly payment will show up on your income and expenses statement.
Now that you understand how to calculate net worth, your next question is probably “why do I care about net worth”?
Why net worth is important
Net worth equals financial freedom.
As you accumulate more assets and pay off your liabilities, you are increasing the amount of time that you can live off of your nest egg. The more time you can live off of your assets, the more free you are. This is how to increase net worth.
Can net worth be negative? Yes! If you have more financial liabilities than financial assets, then you have a negative net worth.
Think of this…
If you make $1 million dollars and spend $1 million dollars, then you are broke. You have saved nothing and have not created any financial wealth.
On the other hand, if you make $1 million dollars and spend $500,000 then you’ve created a half a million dollars of net worth.
If your focus is solely on increasing your income and you ignore your net worth, then you will be broke.
By focusing on growing your net worth then as your income grows, your net worth will also increase.
Aligning your financial habits to net worth increasing activities will help ensure you are always becoming more rich.
How to increase net worth
Increasing net worth comes down to two things – making more than you spend and investing aggressively.
By making more than you spend, you create excess cash flow that then has the ability to be invested to generate additional returns for you.
As your income increases, you will already have built the muscle of making more money than you spend and you’ll be able to save more aggressively too.
The more you invest, the more your net worth will go on autopilot and continue to increase automatically.
It is important to consistently do weekly financial reviews and monthly financial reviews to increase your net worth.
What should your net worth be by age?
Calculating your net worth by age is a difficult task. Determining where to invest is a difficult task as well.
Financial Samurai has a great post outlining where your net worth should be by age. I love following this blog and highly recommend signing up for his newsletter.
