Are you wealthy? The answer to this question really depends on how you define wealth? Does wealth mean that you have a certain amount of money? Does wealth mean that you drive a fancy car or live in a big house? Does wealth mean that you have achieved financial independence?
According to Thomas Stanley and William Danko, authors of the best sellers The Millionaire Next Door and Millionaire’s Mind, wealth can be determined by the following formula:
Take your age and multiply it by your gross household income from all sources. Divide by ten (10). This is what your net worth should be.
This is one definition of wealth. One of the components in this formula is something called net worth.
What is net worth?
The definition of net worth is very simple. Your net worth is equal to all of your assets less all of your liabilities. It can be complicated depending on what you consider an asset and what you consider a liability. For example, is your $1,000 computer considered an asset? More importantly, should it be used to calculate your net worth?
For the purpose of retirement planning and wealth planning, I would argue that you should not consider the computer as part of your financial net worth. In my mind, your financial net worth is slightly different than your total net worth because you only want to consider assets that may be used as a retirement asset?
Why is net worth important?
In the process of financial or retirement planning, it is very important to have a measuring stick. In the area of health and fitness, we use weight as a benchmark. If we are overweight, we try to lose some by eating better or exercising more.
In financial planning, net worth is one of the most commonly used benchmarks. Your goal in retirement planning should be very simple – While you are in the accumulation phase, your goal should be to increase your net worth every year
Two ways to increase net worth
Most often, when we think of increasing net worth, we think of accumulating assets. There is no question that one of the ways to increase your net worth is simply to accumulate more assets. Forced savings plans are one of the best ways to systematically accumulate assets to add to your net worth. Assets like mutual funds, stocks, real estate, GICs are all assets that help build up the asset side of the net worth equation.
Sometimes the other side of the equation is forgotten when it comes to increasing net worth. It is important to keep in mind that reducing debt will also contribute to your net worth positively. Paying down mortgages, lines of credit and credit cards will all reduce liabilities and enhance your net worth. It is also worth mentioning that going into debt is not good for your net worth unless the money is used to enhance your assets. For example, buying real estate is good even though you have to go into debt to do it. However, buying a big screen TV on your credit card would not be considered a positive contribution to your net worth. I know some of you may jokingly disagree but remember your TV is a depreciating asset for personal use. Few experts would consider a TV a solid retirement asset
Do you know your net worth?
I ask this question of people every single day and more often than not, people have to think pretty hard about what is their net worth. If you want to have a benchmark for wealth, retirement or financial fitness, make sure your starting point is your net worth. Take a piece of paper and on one side of the page write down all the assets that you think contribute positively to your financial well being. On the other side of the page, list all your debts. At the bottom of the page, take your total assets and subtract your total liabilities and you will have your net worth. Once you have this starting point, every year, you should redo this calculation to see if you are moving in the right direction. Understanding your net worth is the starting point to financial planning and wealth management.
If you have any doubts about how to calculate your net worth, consult a financial advisor for help.