My posts thus far have mainly been focused on setting goals and taking ownership of our lives. I'll certainly be writing more about those topics, but I'd like to break into another topic area that is always on my mind.
Personal finance.
I want to be wealthy. I want you to be wealthy. It's something that I want not because I'm a very material person, but because I seek many of the comforts that financial stability brings. Financial stability brings with it reduced stress over financial matters and increased opportunities to do the things that we want.
In the hustle and bustle of modern life, becoming financially stable isn't an easy task. If it's something that you've struggled with, don't be ashamed. There are lots of activities, side-tracks and even generally-accepted bad behaviors that carry us away from financial stability. The road to financial stability is not an easy one; it's one that requires huge amounts of discipline and a certain amount of financial understanding. Financial stability doesn't happen overnight. It doesn't happen by just having a stable job. Financial stability and building true wealth takes time, long-term planning and a commitment to your own personal long-term wealth.
When it comes to analyzing my own financial position and charting my progress, there is one calculation that I think matters more than anything else:
Personal net worth.
There are literally thousands of financial formulas that a person can learn, but unless you can calculate your net worth, you're going to have a hard time understanding your own financial situation and growth.
So what is net worth? Simply put, net worth is just the grand total of an individual or organization's assets (cash, property) minus their liabilities (credit card debt, mortgages, etc). Calculating net worth only requires some basic additions and subtractions to complete. It's first grade stuff.
Why is calculating your net worth so useful? When you calculate your net worth, the resulting number gives you an idea of your financial position with all things considered. Let me give you an example of why this is so important and powerful.
Imagine that you have a friend named Frank. Frank bought a home a year ago for $200,000 and had $5500 cash in his bank account after the purchase. To purchase his home, Frank made a 5% down-payment and mortgaged the remainder. When he purchased his home, Frank told you how excited he was to start building wealth and how gratifying it is to be a home owner.
At present, a year after his home purchase, you bump into Frank again and ask him how he's enjoying his house. He's overjoyed with how things are working out for him. He tells you about how he got a raise at work after purchasing his home and has been able to pay down his mortgage principal by $10,000 in the last year. To celebrate, he has just bought himself a new car for $17000 with 0% down and took a month-long vacation to Europe at a cost of $4,000 which he billed to his credit card. Frank also tells you that he still has the $5500 saved in his bank account and feels that he is on a great financial path.
You smile cautiously at Frank and wish him a good day. You worry about his financial future.
Why do you worry? Let's calculate Frank's net worth to see what's what:
Year 1 Net Worth: Assets - Liabilities = ($200,000 + $5500) - $190,000 = $15,000
Year 2 Net Worth: Assets - Liabilities = ($200,000 + $5500) - ($180,000 - $17000 - $4000) = $4500
Even though it looks like Frank is living a pretty good life, he has managed to decrease his net worth by $10,500 or 70%. Frank doesn't know it, but his past year has been a financial disaster. To make matters worse, his use of his credit card and car purchase will have saddled him with additional interest payments that will lay waste to his income. Despite what he says, Frank is not on a great financial path. Frank is marching towards bankruptcy and financial ruin. Don't be Frank!
How to Calculate Your Net Worth
Frank's situation is a scary example, but it's one that you may not have to look very hard to find, even among people you know. What's most important about the example I've provided is not the numbers involved but the percentage change year over year. If you calculate your net worth on a regular basis you can use the resulting values to track your progress towards wealth and financial stability. Here's how:
Once again, the formula for calculating your net worth is simple:
Net Worth = Assets - Liabilities
When I calculate my own net worth, for clarity sake, I like to break Assets and Liabilities down into small things. Here's the template I typically use:
- Assets
- P - Real property - Your house, apartment, land, etc. I generally use the purchase price of the property for calculation sake. If you want to be fancy, you can correct the purchase price for inflation, but be cautious of using the market value as this can fluctuate violently if conditions turn poor.
- C - Cash - The money in your bank account. This should include money that you have set aside as savings.
- R - Retirement Savings - If you have a 401K or an RRSP, you can include the total balance as an asset. Even though these funds aren't available for your immediate use, they do form an important part of your growing net worth.
- S - Securities investments - Your stock, bond, etc. portfolio. Calculate the total market value of your current holdings.
- OA - Other assets - Vehicles, equipment, etc. Be cautious of how you value items that fit in this category. I often exclude it all together. If you purchased a car a year ago for $10,000, it likely wouldn't fetch the same price if resold. Items in this category will be subject to depreciation and you should depreciate their value as required before adding them to your net worth calculations. Exclude all together items that you own that depreciate rapidly or can become worthless rather suddenly. For example, if you just bought a $2000 laptop, you should consider that money as good as gone. Don't count it as an asset, because if it breaks or is lost, it's worthless to you.
- Liabilities
- M - Mortgages - If you own real estate, you may also have a mortgage. This is a huge liability against your net worth. Be certain to include the amount of remaining principal you have left to pay off in your net worth calculations.
- CC - Credit Card Debt - Credit cards are heavily used by many people. If you have credit card debt, you must include the remaining principal in your net worth calculations. Don't worry about including interest payments as liabilities, just consider what you owe. The impact of interest on your net worth will become very apparent as you calculate your net worth month over month.
- L - Loans - Student loans, home equity loans, car payments etc. Take the principal owing of all other loans you have and include them here.
- OD - Other debt - Personal loans, store credit, etc. If you owe any other money, be sure to include it here.
Net Worth = (P + C + R + S + OA) - (M + CC + L + OD)
Try calculating your own net worth right now. The result might surprise you.
When to Calculate your Net Worth
You can calculate your net worth as often as you like, but you should be sure to do it at least monthly. Over time, you net worth values will fluctuate as your financial position improves or worsens. What you want to see is that your financial decisions are creating growth in your net worth.
Calculating a percentage gain (or loss) against your net worth each month can be incredibly useful as you track your progress. Big purchases that you can't avoid or bad investment decisions might cause your net worth to fall, but your overall goal should be to see your net worth consistently grow. If you look at your net worth and see that month over month your net worth is growing by a few percentage points each month, you're on a good track.
Spreadsheet software such as Excel or Google Docs is a great way to record each month's net worth and calculate your growth. As with anything financial, use your net worth calculations to spot trends and identify opportunities for further growth and savings. Do it monthly, and I promise you'll find ways to improve your financial position and increase your net worth.
Trends to Watch For
As you calculate your net worth month over month, you'll begin to notice some trends. Here are a couple that may stand out:
- Interest payments
- If you have a mortgage or credit card debt, calculating your net worth will put the financial cancer of interest payments front and center in your life. If you make $3000 in a month in net income and know that your living expenses are $1000 a month, you would expect to see your net worth increase by $2000. If you have interest, it won't, and you'll know why. When you see the toll that interest takes on your net worth, I promise you'll be filled with motivation to pay down your debts.
- Securities investments
- If you have a stock market portfolio, you may see violent fluctuations in your net worth if the general market is performing poorly. Use this awareness to temper your stock investment decisions. If your stock positions could send your net worth into the negatives if the market faltered, consider revising your positions. Never put all your eggs in one basket.
- Cash
- If you have a lot of cash on hand, month after month, you'll likely start to recognize that it's not doing your net worth any favors. Cash in the bank doesn't grow quickly. If you have some to invest, research ways that you can use your cash to grow your net worth. You should always have some cash around for emergency situations (vehicle repairs, sickness, etc), but if you have a very swollen bank account, find a way to use the cash that will hasten your net worth growth.
Net worth is a simple formula with powerful implications. Use it!
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