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What Does Your Net Worth Really Mean?
One of the most useful calculations a person can make when it comes to their personal finances is to figure out their net worth.
The actual calculation of net worth is really simple. You just add up the value of all of the things that you own – the value of your home, the value of your cars, the value of your savings accounts and investment accounts and retirement accounts – and subtract from that the value of all of your debts. The resulting number is your net worth.
Theoretically, your net worth is what you would have in cash if you sold every significant possession and paid off all of your debts. If your net worth happens to be negative – which is the reality for many people freshly out of college – your net worth is how much debt you still owe if you sold every major possession you have, emptied out every account, and tossed all of it toward your debt.
In reality, it’s not quite that practical. You aren’t going to sell off your house or your car at the drop of a hat. For many people, at least some of their assets are in retirement accounts or education accounts that have restrictions on immediate withdrawals.
In other words, your net worth isn’t really a true number of how much cash you could have if you tried to balance everything.
So, what good is it? What does your net worth really mean?
For me, a net worth is mostly useful as a way to gauge many different kinds of personal finance progress all at once.
Why? Virtually every good financial move you make raises your net worth. At the same time, most poor financial decisions you make drops your net worth.
If I spend too much at the store, I’ve either lowered my checking account balance or raised my credit card balance. In either case, my net worth goes down.
On the other hand, if I’m frugal with my money and find a way to reduce my monthly food and household spending, that part of my budget is going to have a surplus at the end of the month. My net worth goes up.
At first glance, paying off debt might seem like it doesn’t help your net worth, as your checking account goes down at the same time and for the same amount as your debt balance. However, your debt is now triggering lower finance charges, which means that in future months, less of your money will go to the bank and your net worth gradually heads upward because of your debt payments.
You can look at almost every financial move in this way. Good investments? Your net worth goes up. Retirement savings? Your net worth goes up. Shopping spree? Your net worth goes down.
That’s why, to me, the real value in a net worth calculation is the ability to compare it to earlier calculations.
So, sit down today and calculate your net worth. Add up all of your assets, subtract all of your debts, and record that number. For a step by step guide, check out How to Calculate Your Net Worth
By itself, that number doesn’t mean much, of course.
Over the next month, though, keep an eye on the financial choices you make. Are you spending unnecessarily? Are you living frugal? Are you putting away money for retirement?
At the end of the month, calculate your net worth again. Compare that number to the month before. Did your net worth go up? Or did it go down?
Keep doing it over and over again, each month. Compare it to previous months. Some months will see a nice increase. Others will not. It’s well worth your time to figure out why.
Over time, your net worth should be going up. I often compare my net worth over the course of a year. So, for example, I recently compared my September 2012 and September 2013 net worth numbers (I calculate it usually on the first weekend of the month), and I was happy with the increase.
Even more, if you’re shedding debt, your net worth should actually be going up at a faster rate as time passes. Why? If you’re lowering your debts, less of your money is going to the bank in the form of interest each month.
So, why is your net worth important? Not only does it quickly assess your financial health in one number, it allows you to track your financial improvement (or decay) over time. You can see the actual impact of all of the financial moves you’re making, from debt repayment to frugality, from retirement savings to bargain hunting. It can tell you at one glance whether you’re slacking off or whether you’re making progress.
That’s why net worth is well worth calculating.