As I mentioned in 2 simple components for calculating net worth, your net worth is comprised of your assets (add up everything you own) minus your debts (subtract everything you owe). But, why should you know your net worth?
Why is your net worth important?
1. Net worth exposes your overall financial health
Knowing your net worth will shed some light on your finances and help give a clear picture of where you are. Are debts dragging you down? What are you going to do if an emergency comes up? Do you have money you can set aside in an emergency fund? And, the BIG question, do you have enough for retirement? Or, is your net worth increasing at a rate such that you can retire at a reasonable age?
In general, Americans tend to benchmark financial health in terms of wealth. Net worth is, perhaps, the most accurate measure of wealth. Merriam-Webster defines wealth as, “abundance of valuable material possessions or resources.” Most people consider money a “valuable material possession.” Therefore, the higher your net worth, the wealthier you are, and the better your financial health is.
2. Net worth provides a way to track financial progress
What is one of the first things you are going to look at when deciding if you can retire? That’s right, your net worth. If retirement is your goal, then most of your net worth is probably tied up in something that provides passive income (i.e.: rental property), or it is in some sort of retirement account. The higher you want your annual drawdown rate to be, the higher you’ll need these to be, meaning a higher net worth.
Annual drawdown rate means what you plan to pay yourself in retirement. It’s often measured by the year, sometimes broken down by month. You can think of it as a salary you pay yourself in retirement. Think of the 4% Rule, for example. That rule is basically taking 4% of the value of your retirement account every year, adjusting for inflation as you go along. You can read more about safe drawdown rates in my Trinity vs FireCalc article.
3. Net worth is used when taking out loans
I’m not a fan of taking on debt, but it’s worth mentioning. Often, in addition to your credit score, a lender will want to know how much cash you have. You will spend a good amount of time providing the lender account statements, credit card statements, and information about any other debts you may have. Yes, they will review the statements line by line looking for any money bleeding out from any accounts.
Why do they do all of this? Well, that part is simple. They want to make sure you will pay them back. And, if you don’t pay them back, they want to make sure they have other means to recoup that money. The higher the risk that they won’t get their money back, usually means a higher interest rate, or denial of the loan. Having a positive net worth makes it much more likely they will recover the funds they lend to you. The more money you have, the more readily they will lend money to you. Even if your net worth is at a point where it doesn’t make sense that you would need a loan. At that point, it’s basically guaranteed money for them.
4. Net worth will guide your path
Point #1 talks about where you are. Point #2 is more about how far you need to go. This point is about what needs to be fixed to get from point 1 to 2. The obvious answer is, to increase assets while decreasing liabilities. But, what does that mean?
How are you going to increase your assets? Do you plan on working hard, becoming an expert in your field, and, as a result, getting promotions? Are you going to have a side hustle or multiple side hustles? What about increasing your saving’s rate by decreasing other areas, such as shopping? How about moving to a lower cost of living area. There are a number of ways to start building assets, but it isn’t necessarily easy. It takes some sacrifice. As the saying goes, “If it were easy, everybody would be doing it.”
How are you going to make this happen? It’s time to pay off those debts. Student loans, auto loans, even mortgages. Paying off your mortgage verses investing that money (i.e. increasing assets) is a whole other discussion that I don’t want to get into here. But, in case you’re wondering, I am in the Pay Off your Mortgage camp.
Hopefully, once you start thinking about your financial future, you will stop choosing to go into debt. Once all that old debt is paid off and there’s a big, fat 0 for liabilities, you can really start building up your assets and your overall wealth. Imagine what you can do if you take the money that was going towards your debts, you avoid lifestyle inflation, and you just put all that money into investments? It starts building momentum and starts getting exciting! Ah, now your net worth is starting to feel important.
No matter where you are money-wise, knowing your net worth can help you measure how financially healthy you are, and it can help you plan for your future. Net worth is an accurate and valid measure of your wealth. It provides one of the best ways to track your financial progress. A simple review of your assets and liabilities can help lead you to making changes now that will lead to BIG changes (in a good way) for your future. Lack of planning often results in failure. I’d call that foolish behavior.
For the wise person, net worth figures will motivate you to invest in your future. In the long run, the sacrifices you make now will not seem like that much when you look back on them. As you start tracking your net worth, it will provide encouragement as it grows and demand action when improvement is needed. No, I don’t mean taking your money out of the stock market during a recession because your net worth decreases, but rather avoiding more liabilities or being disciplined to get rid of debt. Calculating, and tracking, your net worth will cause you to ask, “Why?” Why am I doing this or that? Net worth really puts the amount of debt in perspective and avoids an over emphasis on assets or income.
Do you track your net worth? Who or why not?