In the personal finance world, we talk about net worth a lot. Most people are focused on measuring their net worth…comparing it to their past net worths…comparing it to others. There is even a subtopic in the personal finance community focused on figuring out what your net worth “should” be at any given point in your life. Is it higher than average? Lower? Average of what? What does it mean? What do you include? Oh, the questions!
I wanted to explain what net worth is for those who don’t know, and then talk a little about what it isn’t. So many people get wrapped up in this one number and, IMHO, aren’t using the information correctly. So let’s look at the concept of net worth, then talk about what it means.
Net Worth Definition: What It Is
Net worth is simply an accounting of your assets versus your liabilities. Add up all of your assets with an identifiable value, subtract your debts, and boom! You have your net worth.
Net worth applies both to individuals and businesses, but I’ll only be talking about personal net worth here.
You can have either a positive or negative net worth. In fact, it’s quite common for young adults to have a negative net worth. Between student loans, buying cars and furniture, and what is often the lowest pay they will receive in their careers, it’s really not surprising. I personally started my career with a negative net worth in the mid-five figures range. Ooof.
Net worth is handy for figuring out how close you are to financial independence. Many Americans no longer have pensions, and many people won’t receive an income during retirement except maybe from Social Security. For the most part, we rely on money we can derive from our assets to fund our retirement. So it’s a useful metric to know.
Net worth is also a good way to measure your financial progress. If you were to plot out your net worth on a chart, the line would hopefully go up over time. There may be some dips that correspond to market corrections or emergencies, but hopefully the overall trend is up. Until you actually retire, that is. It can start heading slowly downhill at that point. Not too steeply, please.
How To Calculate Net Worth
Simply put, the way to calculate your net worth is to add up all the things you own that have value (including things with outstanding loans). Then you add up all the money you owe to people, from the mortgage on your house to the $500 loan from your parents. Subtract the first number (assets) by the second number (liabilities) and you have your net worth.
Assets – Liabilities = Net Worth
That is the simple, easy to calculate version of net worth. But it’s money, so of course there are a lot of interpretations on what you should and shouldn’t count. Let’s go over those quickly.
The Great House Value Debate
The most common argument surrounding net worth is whether to count your house value when calculating your net worth. On the one hand, people argue that it’s often the thing people own that has the most value, so of course you should count it. If worse comes to worst, a house can be sold to recapture equity.
The other side of the debate is that you need somewhere to live, so you shouldn’t include a home in your net worth because it isn’t going to help fund your lifestyle. I’m of the opinion that this argument makes sense on the surface, but doesn’t stand up to scrutiny. After all, people who don’t own houses still need to live somewhere. We don’t reward people who rent by changing their net worth calculation. Why would we penalize people who are slowly increasing their share of a marketable asset every month?
Of course, part of my mindset is affected by the fact that I’m not tied to any particular house. I have no strong feelings about the specific building I’m going to live in, so I approach every piece of real estate as an investment. If you are in the “I’m going to die in this house” camp, maybe it makes a little more sense not to include the value of the home in your net worth calculation. Although, I’d recommend doing what I lay out below – calculate your net worth with and without the home. Problem solved!
What about cars and other goods?
If you have an antique collector’s vehicle worth $100,000, it makes sense to me to include it in your net worth. That’s an investment. But a 7 year old Toyota? Nah. I wouldn’t include that.
I used to, back when my net worth was negative or in the very low positive range. My car was newish at that point, and could have sold for most of what I still owed on it if I needed to sell it in an emergency. But at the time, I still needed a vehicle so I would’t likely have actually sold it. Plus, including it was mostly just a mental boost. I no longer include daily use vehicles in my net worth calculation.
I also wouldn’t include collectibles unless they have significant, provable value. High end, sought after art is an investment. Beanie babies aren’t (or shouldn’t be, at least).
Income Producing versus Non-Income Producing Net Worth
If you are torn over the arguments of what to include in your net worth, you can always do two calculations. Calculate your income producing net worth that will help you retire, and your non-income producing net worth that just shows overall assets and liabilities. The second one may not be fully useful during your lifetime, but could help you understand what you can leave to your heirs when you pass away.
Here’s what I’d include when calculating an income producing net worth:
- All bank and brokerage accounts, including retirement accounts
- The value of any real property that will help fund retirement (rentals – definitely; primary home – only if it will be sold at/near retirement to recapture gains)
- Collectible items that are easily converted into money (jewelry, precious metals, antiques, etc)
This is what I would not include when calculating income producing net worth:
- Depreciating assets that I intend to fully use (vehicles, appliances, clothing, etc)
- The value of any property I intend to keep and use for myself
What Net Worth Isn’t
Net worth is not, I repeat not, the total portfolio size you need to fund your retirement. I’m planning to write an entire post on this so I won’t get into too much detail here, but I keep seeing people talk about how they need an invested portfolio of $x,xxx,xxx because then they can use a safe withdrawal rate of x% to derive an income of $xx,xxx which will cover all of their retirement expenses.
This is, in my opinion, an overly simplistic look at how you will derive money and spend it in retirement. Like I said, I’ll be writing a separate post on that soon, so I’ll go into more detail later. But long story short, I think this mindset ends up keeping people in the work force longer than they need to be. Or possibly shorter than they need to be, depending on what exactly they are considering in their retirement plans. More to follow.
Everything above is a technical discussion of net worth. Now let’s get into some of the psychology behind it.
Net worth isn’t a measure of your worth as a person.
You already know this, right? Right?
Net worth isn’t indicative of financial independence when applied broadly
In order to see whether net worth is enough for financial independence, you have to look at that particular person’s situation. A person with a $200,000 net worth who spends $20,000 each year is a lot closer to financial independence than someone with a $500,000 net worth who spends $125,000 each year.
You can’t just think “anybody with a net worth above $xxx,xxx is financially independent.” Same applies to thinking they are rich.
Net worth isn’t something you should use to compare yourself to others
Everybody’s situation is different. None of us has the exact same amount of debts and assets. So two people with the same net worth won’t have the same assets and liabilities. Consider this:
- Person A has a home valued at $300,000. They also have a $200,000 mortgage, $10,000 in credit card debt, $20,000 in car loans, and student loans of $30,000. Assets ($300,000) minus liabilities ($260,000) gives Person A a net worth of $40,000.
- Person B has $40,000 in their 401k. They also have no debt. Person B has a net worth of $40,000.
- Person C has four rental properties with a total value of $1,000,000. They always purchase the homes with 0% down and have only owned them a short amount of time, so the mortgages total $980,000. They also have an emergency fund of $20,000. Assets ($1,020,000) minus liabilities ($980,000) means Person C has a net worth of $40,000.
These are three very different situations, but they all have the same net worth.
Conversely, you shouldn’t look at someone with a different net worth and think that you are financially better or worse off than that person based on net worth alone. Money isn’t that simple. After all – a newly graduated physician specializing in anesthesiology may have a lower net worth than me due to their student loans, but their human capital and future potential earnings significantly outweigh my own.