What is Your Net Worth and Why Does it Matter?
What is your net worth? Do you know? Why is it important? What steps can you take to increase your net worth? In this article we will go over these questions and put you on the path to financial freedom.
Net Worth Definition
Net worth is the difference between the value of your assets, minus your debts. If your net worth is positive, you are said to be solvent. If your net worth is negative (debts are larger than assets), you are insolvent.
Assets – Debts = Net Worth
To understand this definition, you have to first know what is an asset and what is a debt (liability). In simple terms, an asset is something of value. Assets can be things like: houses, cars, retirement accounts, real estate investments, stocks, bonds, gold, silver, land, furniture, clothing, jewelry, and electronics.
The best kinds of assets are ones that continue to put money into your pocket – some would even argue that it isn’t an asset unless this criteria is met. We tend to agree.
A debt or liability is anything owed. People’s most common debts include: mortgages, student loans, car loans, and credit card balances. It is best to avoid debts that you have to personally pay for out of your own pocket. If you take on large debts, make sure someone else (ex. tenant) pays for them.
If you have a large positive net worth of, say, over $1,000,000, people will say that you are a millionaire. Many people want to become millionaires prior to retirement. Though this financial statistic seems very simple, let’s throw in a few observations.
Not All Assets and Debts Are Created Equal
How Assets Can Vary
Not all assets are equally valuable. Some retirement assets are pretax accounts. This means that you don’t pay tax on the money at the time you put it into the retirement account. Regular IRA and 401-K assets fall into this category. They aren’t easily liquidated prior to age 59 ½ without having to pay taxes and penalties.
Even later in life, withdrawing those assets means that you will have to pay income taxes. For example, let’s say that you are in the 25% Federal tax bracket and your state tax rate is 5%. If you withdraw the assets, you will pay at least 30% in income taxes. In this case, the assets might be worth only 70% of their stated current value. While this isn’t always calculated into your net worth, it should at least be understood.
Some assets (stock equities, real estate) tend to appreciate over time, while others almost always depreciate (automobiles). An appreciating asset goes up in value over time while a depreciating asset goes down over time. When calculating net worth, you have to consider the current value of these types of assets.
Some assets are useful to you but have little market value (many collectibles and personal items). These types of assets will add to your net worth number but don’t really affect your wealth. This is because it is very difficult to sell them for what they are worth on paper.
How Debts Can Vary
Debts also come in various shades. Personal credit card debt is often viewed very negatively. This is due to the high interest rates that can make the debt difficult to repay.
If you want to own your own home, personal mortgage debt is almost always a necessity. It often comes with favorable interest rates and long repayment terms.
Business debt can be the best kind of debt. For example, if you buy rental real estate, the debt allows you to leverage your returns higher. This is because you control 100% of the property but maybe invested only 25% of the cost.
When you buy positive cash flowing real estate investments, other people fund the debt payments. How does this work? The tenants are paying the debt off each month as part of their rent payments. These debt pay downs by others can increase your personal net worth while requiring no real financial sacrifices from you.
Why is Net Worth Important?
First, if you have a large positive net worth and a high enough store of liquid assets, you will have the financial capacity to acquire more assets. When you purchase more assets, you continue to increase your net worth. This is part of why the rich continue to get richer – they have high net worth and the liquidity necessary to acquire more assets.
Second, if you have been a wise steward over your debts, then your credit rating will be strong. That demonstration of your responsible behavior will make it much easier to enter into new financial transactions. Being able to acquire new debt to purchase cash-flowing assets accelerates the growth of your net worth.
Ultimately a high net worth will enable you to achieve your life goals. These goals could include a wonderful retirement, travel to exotic locations, helping your family and others, or being able to pursue other dreams.
What Steps Can You Take to Increase Your Net Worth?
Improving your net worth takes time, discipline, and savvy. We all have heard stories of athletes and movie stars that have made it big only to lose everything. This can almost always be attributed to a lack of discipline and knowledge. How can you avoid the same pitfalls?
First, create a net worth statement to see where you are now. Sort the information into categories of the various kind of assets and debts that you have. Determine the difference between your assets and liabilities. Monitor that difference over time to see whether you are making progress.
Some steps are very important such as: budgeting, controlling your spending, avoiding bad debt, and paying all your debt obligations on time. Enhance your financial knowledge. Work to understand the impact of tax laws on you and your activities. Reducing your taxes can be very helpful to improving your net worth. Seek to achieve high rates of return on your investments.
A Client Example
A client who is new to real estate investing called me recently. She is a new investor and wanted to know how to proceed. My recommendations included joining her local real estate investing club and reading books about real state investing (to increase her knowledge). From there, she could work to purchase a duplex or fourplex property. A great part of this is that others can help her to reduce her housing costs so she will have more money to invest.
Real estate will provide an opportunity to convert some of her otherwise personal expenses into tax deductions. These deductions are associated with the business, thereby also providing more cash flow to invest to increase her net worth.
As you progress in your financial knowledge, you likely will decide to start a business or begin to invest. For both activities, having a source of financial capital is essential. Work to gain an understanding of what will attract money to your projects.
You should also know how to model business opportunities, analyze financial information, and calculate key financial statistics. Those include more advanced concepts such as: debt coverage ratios, net operating income, internal rates of return, and net present value. A variety of good books are available to help you gain that knowledge.
To master and grow your net worth, you must first know your net worth. If you don’t already, gather a list of your assets and liabilities and calculate how much you are currently worth. Analyze each asset and debt to understand their true value. Once you have this understanding, work to further your financial education and grow your net worth.
If you run into problems, we’re here to help. If you decide to invest in real estate to grow your net worth, let’s talk.