How is your health? I am not talking about whether you have the flu. I am talking about your financial health. There are many indicators of your financial health but the one most used by financial planners is your net worth. It is probably the most important measure of your personal financial health, yet most people don’t even know about it and have never calculated it.
Many people determine their financial health by their income, how much money they make. But if you spend it all or even spend more than you make it isn’t very accurate. Some people determine their wealth by how much they have in savings. Some people determine financial health by how big their house is or where they live. But these methods have a serious flaw. They don’t take into account any debts you might have.
Your net worth is calculated by adding up the assets you have and subtracting your liabilities. In English it means you add up all the things you own and subtract what you owe. If you have ever taken out a home loan the bank did this to determine whether to give you a loan and how much interest you were going to pay. They asked for all of your assets which are savings, retirement assets, other real estate you own, business and personal assets and cash. Next they asked for all of your liabilities or what you owe including, mortgages, student loans, credit cards, business loans, personal loans, car loans.
That one number, your net worth is the single best yardstick you can use to measure where you are now. The whole idea is to figure out your net worth to establish at point from which you can move forward. For most people, increasing your net worth to a certain level before you retire should be your main goal. Your net worth should increase throughout your life.
Now that you know how net worth is calculated you can see that increasing your assets and reducing your debts is the way to go. Each financial decision should be made with the goal of increasing your net worth over time. Let’s take a couple of examples. Say you are considering buying a rental property but you would need to borrow 80% of the money for 15 years. In the short term you are taking on debt, but you are using the rent you receive to pay off the debt in the long run. So in 15 years you will have an asset that has probably increased in value, increasing your net worth and as an added bonus produces income with no debt.
In the second example you trade in your car worth $10,000 and buy a brand new $35,000 SUV. So you borrow $25,000 for 6 years. In 6 years the debt is gone and your SUV is worth $10,000. So the decision to buy a new car has made no impact on your net worth plus you are out probably over $30,000 in car payments. Instead of buying a new car that depreciates 10% as soon as you sign the loan papers you would be helping your net worth by buying a used car and paying cash.
To increase your net worth you need to spend your money on things that appreciate not things that depreciate. The middle class in our country is defined by how much stuff and how many toys they have. These things generally go down in value really fast as soon as you buy them. So if you have money tied up in lots of stuff it is generally not helping your net worth. It is no wonder then that many people who appear to be doing well have little to no net worth. If you look at each spending decision as an addition or subtraction from net worth many things people buy just don’t make sense.
Investing the money in things that gain in value over the years adds to your net worth. Although they are not as much fun as toys, these investments will increase your net worth to the point that some day in the future you may be able to afford a few toys.
Bill Oldfather is a fee-only financial planner and investment advisor. Oldfather Financial Services is an SEC Registered Investment Advisor based in Kearney NE. Email to [email protected]