What does 'net worth' mean?
The most useful definition of net worth you'll ever hear in less than 10 words:
How much you have minus how much you owe
A fancy term for "how much you have" is "Total Assets"
A fancy term for "how much you owe" is "Liabilities"
So you will often see something like: Newt Worth = Total Assets - Total Liabilities.
Assets include money or things that are worth money. Again, this is the "how much you have" part. Some examples can include:
- Cash on hand
- Money in the bank
- A house
- An investment account
- A business
Liabilities are the debts that you owe. Examples include:
- Credit card debt
- Student loans
- A mortgage
So your net worth can fluctuate in a few different ways:
You make money: This immediately causes your net worth to go up.
You spend money: This immediately causes your net worth to go down*
You take out a loan: This immediately causes your net worth to go down
An asset changes in value: This can cause your net worth to go up or down depending on whether the asset appreciated or depreciated in value. If you own a home and goes up in value by $10,000, your net worth goes up by $10,000. If the value of the home declines, your net worth declines by the same amount.
*If you are spending money on an asset, then theoretically your net worth stays the same in the short term, since you lose money but gain an asset worth an equivalent amount. In practice however, your net worth still goes down in the short term due to transaction costs. For example: Let's say you buy a $200k house with a $40k down payment and a $160k mortgage. In theory your net worth goes up by $200k because you now on the house, but it goes down $40k because of the cash leaving your bank account and it goes down $160k because of the loan you are taking out. On the surface this looks like a wash, but in practice you'd pay closing costs of maybe $5k or so. This means that at the end of the day, your net worth will be about $5k lower.
Why think about net worth?
When it comes to your finances, there are two basic scorecards that everyone should know: net worth and savings rate.
Net Worth is the current state of your financial health. If it's negative, you're in a really bad spot. If it's positive, your in a really good spot.
The problem with net worth is that it has no context and no indication of where it is going.
To figure out if you are doing a good job managing your money, you should think about your savings rate.
Your Savings Rate is the percentage of your income that you keep for yourself.
Here's a simple formula:
(Take home pay - spending)/take home pay
You then have to multiply it by 100 to turn it into a percentage.
Some people might object that this formula is a little blunt and that you should use gross pay but adjust for taxes. Fair enough, but if you're intimidating by math or money (or both), the simple formula works just fine.
Your savings rate is important for two reasons. First it tells you whether or not you are spending more than you are earning. This is probably the single most critical thing you need to know.
But your savings rate also gives you an idea of how quickly you can store up enough money to stop working without even making any assumptions about investment returns.
Think about this:
- With a savings rate of 10% you will have to work nine years to be able to take one year off
- With a savings rate of 90% you could take nine years off after working just one year.
Here's how that works: If you are saving 10% of your income, that means that you need 90% of your yearly income saved up to go a year without working, because that's how much you spend a year. If you are saving 10%, then it will take you nine years to save up 90% of your income: 10% x 9 years = 90%
On the other hand, if you are living off just 10% of your income and saving 90%, then after working just one year you already have enough saved up to get you through nine more years.
Of course, a 90% savings rate is enormously difficult to achieve.
But there are two ways you can increase your savings rate:
- Increase your income (without increasing your spending)
- Decrease your spending.
Pretty much all of personal finance can be summed up with the one sentence "spend less than you earn and invest the difference"
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