Latest posts by Kumiko Ehrmantraut (see all)
- How to Improve Your Bad Credit Score - November 13, 2019
I was first introduced to a balance sheet back in 2012. At first, I didn't understand what it was or how it could help with my financial life. I was in the middle of trying to handle my student loans, working on my credit card debt payoff plan, and trying to stick to my budget. What I didn't realize, is how important and eye-opening a net worth statement is. Today, I want to encourage you to create a net worth statement (also known as a balance sheet), and use it as a tool to understand your financial situation.
WHAT IS YOUR NET WORTH?
Your net worth is essentially everything you own that has value (your assets) minus what you owe in debts (your liabilities). Your assets might include cash, investments, you home, cars, or anything else that you own that has monetary value. Your liabilities are what you owe on those assets such as your car loan, mortgage, student loan debt, or credit card debt.
Your net worth measures your financial health because it tells you what you would have left over if you sold all of your assets to pay off all of your liabilities (Net Worth = Assets – Liabilities). Increasing your net worth should be your primary goal. That means either increasing your assets or decreasing your liabilities.
It's not uncommon for younger people to have a negative net worth. People just graduating from college are more likely to see a negative net worth than someone who has already established a career, and had time to decrease debt. For people who end up with a negative number, this just means that your net worth is how much debt you still owe after you sold everything you have, and applied all of it toward debt.
WHAT DOES IT REALLY MEAN?
It's also important that I mention that your net worth isn't an exact value of how much cash you could have if you tried to equal everything out. For example, most people wouldn't sell their home or car at any given time to pay off their debt. Even though they are assets they can sell for cash, deciding to sell these assets at a moment's notice isn't reality.
So why is calculating your net worth so important?
I use my net worth as a useful way to measure my personal finance progress all at once. Every good financial decision I make will raise my net worth. On the other hand, making a poor financial decision will decrease my net worth.
If I go to the mall and spend too much on clothes, I have either lowered my checking account balance or raised my credit card balance. No matter what payment method I used, my net worth still goes down.
At the same time, if I decide to be frugal with my money and find ways to save on my monthly food and household spending, that will give me a surplus at the end of the month, which will raise my net worth. See how it works?
Now, I must admit that when I first started paying off my credit card debt, it seemed like it didn't help my net worth at all. To me, I was decreasing my checking account balance to pay off debt, and for the same amount. Essentially, I was reducing my checking account by the same amount that I was decreasing my debt. There was no surplus. I didn't realize that every time I made a payment to my credit card, I was now paying less in finance charges in the future.
It's so hard to see the big picture when you are so focused on one financial task (like paying off credit card debt). I didn't even realize that I was improving my financial future by having less of money go towards interest charges, which in turn gradually increases my net worth because of my debt payments.
HOW TO CALCULATE YOUR NET WORTH
Calculating your net worth doesn't require a lot and is simple. It just takes some time, a piece of paper, and a calculator.
→ MAKE A LIST OF ALL OF YOUR ASSETS
Your assets might include retirement savings (401k), checking accounts, savings account, money market accounts, your home, your car, or any other asset of value. This could even include an art collection or baseball card collection. Some people don't bother including small assets that have low values, but I include everything in my net worth statement. To me, this gives more of an accurate picture of my financial health. When you are listing your assets, make sure to write down the value of each asset to the right of the asset name. When your list is complete, total your assets.
→ STEP #2: MAKE A LIST OF ALL OF YOUR DEBTS (LIABILITIES)
Your liabilities might include all of your credit card balances, personal loans, auto loans, student loans, mortgage (home loan), or anything else you might owe. Next to each liability, make sure to list the amount of debt, and then total your liabilities. This will give you the total amount of all your liabilities.
→ STEP #3: SUBTRACT
Take your total assets from step #1 and subtract from that your total liabilities from step #2. The result is your net worth.
WHY IS MY NET WORTH NEGATIVE?
Don't panic if you got a negative number. I had a huge negative number when I started. This just means you haven't earned enough money yet to defeat your debt. No need to worry as this will come with time.
If you ended up with a negative number, it might also be due to overborrowing. This happens when you put huge amounts on your credit cards and are not paying them off. This will create an immense increase in your liabilities section with no valuable assets to offset it. Remember, a poor financial decision will decrease your net worth, and if you don't have the assets to compensate for those poor decisions, you will end up with a negative net worth.
- Related: Should You Pay off Debt or Save?
HOW CAN I IMPROVE MY NET WORTH
If you are wondering how to improve your net worth, you have to focus on either decreasing your debts or increasing your assets. Paying off your debts, saving and making smart investment decisions, and reducing your spending will help increase your net worth.
Your spending plays a huge role in the health of your net worth. Your net worth will decrease if you spend too much money on the small things, such as clothes, food, and even interest charges on your debts. I made the huge mistake of spending money that I didn't have, which increased my liabilities (and my interest charges), which in turn decreased my net worth, and ultimately put mine in the red.
HOW OFTEN SHOULD YOU CALCULATE IT?
Many people only calculate their net worth on a yearly basis. I find it most useful to calculate my net worth every month. It makes it easier for me to measure my financial goals, and see progress on a month-to-month basis. My monthly goal is simple: increase my net worth over the previous month. This means that my expenses need to be less than my income for the month. If I have a surplus during the month, I allocate it to paying off my debts or increasing my savings account.
Remember, the actual number of your net worth might not mean that much, but if you pay attention to the financial choices you make throughout the month, the value of your net worth is eye-opening. Did you spend money on unnecessary things? Are you being frugal with your money? Are you saving more for retirement or emergencies?
At the end of the month, calculate your net worth again, and compare it to the month before. Did it go up? Did it go down?
If you do this every month, you might notice a trend. When your net worth goes down from the month before, try to figure out why. If it went up, look back at how you did it, and try to do even better next month. It's worth finding out how your spending is affecting your financial health.
- Related: How to Create a Plan to Pay Off Debt
Over time, your net worth should be increasing. I compare my net worth over the course of the entire year. So for example, I will compare my November 2016 net worth to my November 2015 net worth at the end of this month. I usually calculate my net worth on the first Saturday of the month. Last month, I had a slight increase in my net worth, but not the huge increase I would have liked to see.
Your net worth is a fantastic way for you to measure your financial health using one simple value quickly, and it allows you to track your improvement (or deterioration) over time. It gives you a way to see how your financial decisions in your everyday life affect your financial health. In one glance you can see if you made poor money decisions for the month, or if you are making real progress.
Today, I encourage you to calculate your net worth and see how your spending affects your overall financial health.
Have you calculated your net worth? What have you learned about your financial health?
[…] How to Calculate Your Net Worth […]