Applying for a mortgage? Writing a will? Or just looking to build your wealth? No matter what your financial circumstances or goals, you can’t plan for tomorrow until you know where you stand today.
The first step of any good financial plan involves calculating your net worth. You need to determine the total value of your assets (what you own), minus your liabilities (what you owe). In effect, you must create a personal balance sheet.
A Three-Step Process
A net worth statement helps you identify the value and efficiency of your assets and liabilities. It helps you determine whether the majority of your assets are growing in value or losing value. You’ll also see how liquid your assets are, i.e: how easily you could convert your assets into cash.
Calculating your net worth can be accomplished in three steps:
Step 1: Add up your assets. Anything you own can be considered part of your total assets.
Here are some areas to consider:
- Cash reserves. This is any money that can be accessed on short notice, such as checking and savings accounts; short-term investments such as money market accounts, certificates of deposit (CDs); and Treasury bills.
- Investments. Stocks, bonds, mutual funds, life insurance, annuities, employer-sponsored retirement plans, and other employee benefits, like deferred compensation plans or stock options, are all investments.
- Personal property. Possessions such as jewelry, furs, wine and electronic equipment are all part of your assets. Some assets, like artwork, antiques or a stamp collection, may appreciate in value, while others, like cars and boats, normally depreciate in value over time.
- Real estate. Calculate the current market value of your primary residence and any vacation homes or investment properties.
- Miscellaneous. This could include a trust fund or equity ownership in a business.
Step 2: Tally your liabilities. Simply put, liabilities are what you owe, both short- and long-term.
Here are some common liabilities:
- Mortgages. This is the single greatest liability that many people have.
- Other secured debt. Auto, boat and business loans are all forms of secured or collateralized debt. Since the lender may sell the items to recoup any losses from defaulted loans, these loans are less risky than unsecured loans; therefore, they typically have lower interest rates.
- Unsecured debt. While some unsecured low-interest loans are offered for special purposes like paying education expenses or starting a business, unsecured debt is generally very costly. For many people, credit cards represent their greatest source of unsecured debt.
Step 3: Subtract your liabilities from your assets.
If your assets are larger than your liabilities, you have a positive net worth. If your liabilities are larger than your assets, you have a negative net worth. In either case, knowing where you stand will help you to work toward a better financial picture.
Your Next Step
Through the process of calculating their net worth, people often find they are worth more than they thought. Whether you’re worth more or less than expected, you can continue to find opportunities to better manage the potential growth of your net worth.
If you have considerably more in assets than in liabilities, take a closer look at the type of assets you own. Are they increasing or decreasing in value? For example, assets such as the cash in your wallet actually lose value as the cost of living increases. Investing in assets that have the potential to grow over time will help you build your net worth.
If, after you have made your calculations, you find you are worth less than you had expected, it may be time to reassess your money management strategies. Too many people concentrate on accumulating assets, and not enough on managing their liabilities. It’s important to manage both sides of your balance sheet.
To increase your assets by saving more, begin by looking at your sources of income and your expenses. There are more ways to increase your net worth than simply cutting back on dinners out and expensive vacations. Finding ways to lower your taxes and restructure your debt can dramatically increase your cash flow. For example, if you carry a balance on your credit cards, research different cards to make sure you’re paying the lowest interest rates available. Or consider consolidating credit card debt with a home equity loan or line of credit, which may offer a lower interest rate and give you tax deductions for interest payments.
Take a second look at your long-term debts. Refinancing your mortgage, especially at today’s low interest rates, could free up cash each month. And reconsider your car loan. You may be better off making car payments by taking out a home equity loan.
These steps can help you free up income that may be directed toward saving rather than expenses. An automated investment program is an excellent way of disciplining yourself into building your investment asset base and net worth.
Protecting Your Worth
Take steps to protect the assets you’ve worked so hard to earn. Consider estate-planning issues, particularly if you are older. By preparing a formal plan that takes into consideration the value of your estate and your tax liability, you can help protect and preserve your net worth for your intended heirs.
Think about the allocation of your retirement assets. If your retirement accounts have been invested in stocks, you may find that the tremendous stock market gains during the past few years have enriched your account, and stocks may now account for a greater percentage of your assets than you realized. This shift could mean you are facing risks you didn’t know about.
Reassess Your Worth
Once you have calculated your net worth and readjusted your financial plan, it’s tempting to file it away and not look at it again. But your net worth is a moving target. It’s important to reassess where you stand periodically to reflect changes in your personal circumstances, such as buying a house or receiving an inheritance. By tracking your progress, you can develop a working plan that will ultimately allow you to reach your financial goals.