April 25, 2022

Invaluable? - Determining Your Net Worth

Eric Bank
Former Citadel Director of Business Analysis

What kind of person would dare to assign a net worth to a living, breathing human being? Well, actually, I can think of quite a few: bankers, brokers, insurance salesmen, real estate agents, your fiancé(e), and the IRS, for starters. Moreover, you'll want to know your own net worth before you start investing or borrowing money. I'll explain why a little further down, but let's define net worth first.

What Is Net Worth?

Net worth is not a difficult concept. It's your assets (what you own) minus your liabilities (what you owe). If you were a company, your net worth would also be called stockholder's (or owner's) equity. But you are just you, and you can calculate your net worth by tallying all your tangible assets (you can't include your winning smile, which is an intangible asset) and your debts. 

For example, suppose you own a home, two cars, furniture, jewelry, gadgets, life insurance with cash value, savings, an annuity, retirement plans, mutual funds, bonds, and stocks. In that case, you'd first add up their total liquidation value (i.e., how much you'd get if you sold each asset). You've done well, so let's value your tangible assets at $1 million.

Now tally all the money you are obligated to pay, such as your mortgage, car loans, personal loans, credit card debt, student loans, and so forth. If your total liabilities add up to $400,000, then your net worth is $1 million - $400,000, or $600,000. Congratulations! Your net worth is positive, and your debt-to-asset ratio is only 40%. Anything below 50% is good, but the lower, the better (up to a point).

Why Do I Need to Know My Net Value?

Your net worth is essential. It's similar to a budget in that it helps you identify where you spend too much relative to your income and wealth. Debt is not necessarily a bad word, but you don't want too much of it. Unnecessary debt limits your freedom of action by draining away some of your money to pay interest and repay principal. High debt levels constrain your ability to save and invest. It also makes you more vulnerable to expensive emergencies because you'll have fewer reserves. 

On the other hand, if you have lots of assets and little debt, you may be sacrificing a better lifestyle and higher investment income. When used well, debt can help you get a bigger home and a more extensive portfolio without endangering your finances. 

Another reason to know your net worth is that it's a critical factor when you want to borrow money. Above all else, lenders need assurance that you'll repay your loans on time. That gets harder to do as your net worth drops. You may find your loan application denied or carrying a high interest rate if accepted.

Finally, knowing your net worth lets you invest rationally, especially if you are impulsive. Understanding how much money you can put at risk is essential if you don't want to expose yourself to losses you can't afford. Tracking your net worth over time can provide insight into how well you manage your money and investments.

A financial advisor can help you make sense of your net worth  —  how it's deployed and where it should be rejiggered. It's worth your time to discuss your net worth with a financial professional. But no matter what, keep that winning smile.

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