Did You Know Your Pension Isn’t Guaranteed?
Sometimes when I talk to people about financial planning, their response is ‘Oh I have...
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Your net worth is equal to all your assets minus all your liabilities. If your assets exceed your liabilities, you have a positive net worth. If your assets are less than your liabilities, you have a negative net worth.
Assets are anything that you own that you could sell and turn into cash. Assets include cash, real estate, investments, retirement accounts, jewelry, cars, and other personal property. Put simply, assets are things you own.
Liabilities are debts that you owe which could include personal loans, student loans, car loans, mortgages, medical bills, credit card debt etc. Put simply, liabilities are things that you owe.
Your net worth is the difference between what you own and what you owe.
Step 1: Add up the total value of all your assets
Step 2: Add up the total value of all your liabilities
Step 3: Subtract your total liabilities from your total assets
For many of your assets and liabilities, it will be quite easy to determine the value. If you have $50,000 in an investment account, you know that is an asset worth of $50,000. If you owe $50,000 on a credit card you know that is a liability worth $50,000.
The trickiest line item to determine an accurate value for most people will be your house. That presents a problem because for many people your house is also your largest asset.
Most people are way overconfident about the value of their own home. They tend to think their home is somehow special and should fetch more than your neighbor’s house on the open market.
Your house might be special to you, but it is the market that will determine it’s financial value. It’s important to know how to properly value your home.
Single-family homes are valued using the sales method. If you want to get an approximation for the value of your home research the recent sales prices for comparable houses in your neighborhood. Zillow is a helpful tool to find comparable home sales.
If you want an exact value work with a real estate agent or an appraiser.
Tracking your net worth allows you to fully understand two things.
If your total assets equal $300,000 and total liabilities equal $200,000 you would have a $100,000 positive net worth. Conversely, if your assets equal $200,000 and your liabilities equal $300,000 you would have a negative net worth.
Having a negative net worth does not mean you are a failure or are bad at managing your finances. It is simply one data point that tells you at this moment you owe more than your own.
Tracking your net worth over time is a much more useful exercise. It provides you with more data points that will build a trend that tells you how you have been managing your finances over time.
Below is a chart that demonstrates what a typical person’s net worth might look like over the course of their life.
Up until about the age of 18 your net worth is likely zero or very close to zero. Some teenagers might have jobs or even some credit card debt, but at this point in life, you have not had the opportunity to have a significant net worth.
From 18 until your late 20’s or early 30’s many people will likely have a negative net worth. Which is fine.
This is the period of your life that you are investing in your future. Whether it be going to University, starting a business or buying your first home (or all the above) all these investments are very expensive which means people at this stage in their life will need to borrow money to pay for these investments.
Once you start you hit your late 20’s or early 30’s most people begin paying down their debts and accumulating assets. At some point, you’ll cross the “zero net worth” point again. From your 30’s until your 60s or whenever you end up retiring is the point where most people see the most explosive growth in their net worth.
The power of compounding interest and years of saving and paying down debt pushes your net worth up.
Once you retire and begin living off your net worth it will begin to fall again. The trick is to make sure you don’t outlive your money.
Tracking your net worth can be a useful exercise to see if you are on track to hit your financial goals.
For example, if your goal is to have a $750,000 net worth by the time you retire at 55 and you have a negative net worth at age 40, you have some serious ground to make up.
If you don’t currently have any financial goal or don’t know where to start, the “wealth equation” can be a good place to get started.
The Wealth Equation was developed by Dr. Thomas J. Stanley, author of “The Millionaire Next Door” who came up with a simple equation that can be used as a rule of thumb for how much wealth you have created given your age and house household income.
Put simply, the wealth equation states that a household’s combined wealth should be equal to 10% of the age of the highest income earner in the household multiplied by the households combined income.
Let’s say you are 45 years old and you have an income of $55,000 and your spouse is 49 years old and has an income of $60,000, what should your combined net worth be?
Wealth equation= 4.9 (10% X 49) X $115,000 ($55,000+$60,000) = $563,500
According to the wealth equation, your household net worth should be $563,500.
If you have been tracking your net worth you can use the wealth equation as a kind of checkup to see how you are doing.
Disclaimer: The information in this article is not intended to encourage any lifestyle changes without careful consideration and consultation with a qualified professional. This article is for reference purposes only, is generic in nature, is not intended as individual advice and is not financial or legal advice.