Net worth is the market value of everything you own, and everything you owe. But it’s sometimes to know what moves my net worth.
It’s vital to understand what it is if you want to have a brilliant grasp on your personal finances.
And yet, many people seem to not understand what makes your net worth move.
So what really moves my net worth?
Here, I’ll explain what really moves your net worth and debunk some of the myths around net worth.
Let’s start with some TRUE or FALSE:
- Net worth is the total of all my assets – TRUE or FALSE
- Net worth is the price I bought an asset for – TRUE or FALSE
- Net worth is all my financial assets added together – TRUE or FALSE
- Net worth is the same as my FI (Financial Independence) number – TRUE or FALSE
- Net worth increases when I save money – TRUE or FALSE
- Net worth doesn’t include liabilities – TRUE or FALSE
- When I take out a loan I decrease my net worth by the loan amount – TRUE or FALSE
- Net worth increases when you buy a house – TRUE or FALSE
If you answered TRUE to any of these statements, read on. You’re about to learn the truth about net worth.
What makes your net worth move?
Believe it or not, there are only three fundamental ways to make your net net worth move.
- Additions – An asset or liability you do not currently own moves into your ownership.
- Revaluations – An asset or liability you do currently own changes in market value.
- Reductions – An asset or liability you currently own moves out of your ownership.
Read those three points closely. Everything about your net worth can be derived if you “get ” these three points.
Let’s break down the points.
First, understand that net worth is the value of things you legally own and owe. Technically, you own your debts too. So your net worth adds up all your assets and then deducts all your liabilities.
An asset addition to your net worth improves your position. A liability addition decreases it.
Revaluations can go up and down, depending on what other people are willing to pay you for your stuff.
An asset reduction is when you give money or other assets away – usually you are spending. A liability reduction is when some amount you owe is forgiven or reduced without you spending money. For example, if your student loan was cancelled, that would be a liability reduction. It’s a relatively rare occurence compared to an asset reduction!
Net worth is the same as my FI (Financial Independence) number
Wrong (for most people)
Your net worth is everything you own or owe.
Some people might be tempted to use this as a way to calculate how close they are to financial independence. The financial independence formula tells to take expenses multiplied by 25 and compare that to net worth to assess whether they are financially independent.
But the FI calculation assumes that your assets are on average making similar returns to a stock market and low cost index fund.
And I’ll bet many of your assets are not making anywhere near those returns. For example, your owned home is not making you any cash and if you can’t sell it to access the funds to live on, its gains are irrelevant. Similarly, your emergency fund may only be earning less than inflation. It’s important, but not part of your FI calculation.
Your FI target should be everything you own that is making a strong return. Plus you need to deduct any debt that isn’t driving an investment return.
Net worth increases when I save money
Wrong.
Net worth does not increase when you save money. I repeat, net worth does not change when you save money.
Why?
When you are paid money, your net worth increases. It’s an example of an addition to your net worth. If you spend that money on expenses, your net worth will go down by the amount you spent. That’s an example of a net worth reduction.
But when you save, you are transferring an asset from one place you own it to another place you own it. If you have cash in your right pocket, saving is the equivalent of transferring it to your left pocket.
Saving is a passive act. It’s the act of receiving money and not spending that money.
It doesn’t matter if that money is under a matress, or left in your chequing account, or used to buy an investment or even to pay off your credit card. In all these examples, your net worth remains the same – its just put in a different place.
Repeat after me: Saving does not increase my net worth.
Does that mean you shouldn’t save money? Of course not. In fact, your savings rate is a key factor for how quickly you will achieve financial independence. If you don’t believe me, you can play with this savings rate calculator. Savings are the tools you use to invest. And the returns from your investments will (most likely) increase your net worth. But the act of saving doesn’t change your net worth.
Net worth doesn’t include liabilities
Wrong
Net worth is the market value of all your assets less the market value of all your liabilities. It is the stuff you own less the loans and debt you owe. It’s what you own and what you owe.
The stuff you own is called your assets. Or you could call it your gross worth. When you deduct the liabilities, you are “netting them down”.
Net worth is the price I bought an asset for
Wrong.
Net worth is a market valuation of what you own and owe today.
The price you paid for an asset is completely irrelevant to the market value of it today.
Okay, it may be relevant to know the old prices of stuff for lots of good reasons like tax, capital gains, return on investment etc – but not for the net worth calculation)
To understand this, just imagine a friend telling you that their net worth is $1,000,000. And then they explain that they bought $1,000,000 of Cryptocurrency a year ago which are now only worth $20,000.
Their net worth is only $20,000 – no matter how painful that news is for them.
You could also watch the Richard Pryor movie Brewster’s Millions to understand that the money you get given is not the same as the same as your net worth.
When I take out a loan I decrease my net worth by the loan amount
This feels obvious, right. If you take out a loan, surely you deduct it from your net assets – so your net worth must decrease by the loan amount.
Wrong.
Your net worth stays the same when you take out a loan. Or only decreases slightly.
Did you mind just explode?
Two things happen in tandem when you take out a loan. First, your liabilities do increase by the size of the loan. But, also your cash balance increases by the size of your loan.
As a result, your net worth does not change when you take out a loan.
This example might help. On the day Megan borrows $1,000, she receives $1,000 in cash. This means her assets increase by $1,000. But she must also pay the loan back in the future, this increases her liabilities by $1,000. Net result – Megan’s net worth hasn’t changed.
Of course, if she had to pay an upfront fee in cash to take out the loan, say $10 – then her net worth would decrease by $10.
Interest on the loan will decrease her net worth over time. Every time an interest payment is due, Megan will owe it to the bank. And owing money to the bank is a type of liability.
This doesn’t mean loans are a good thing or a bad thing. It’s just a fact that taking one out does not move your net assets.
Net worth increases when you buy a house
Wrong.
When you buy a house, you acquire a big asset.
But to get that asset you either bought it with cash or you took out a mortgage. Probably a combination of both.
Other than the transaction fees from the sale, your net worth remains the same when you buy a house.
It’s easiest to think about this if you bought in cash. On the day of the purchase, you pay, say $500,000 to the previous home owner. In return, they give you a $500,000 house. So your cash asset has reduced by $500,000 and your house asset has increased by $500,000. Your overall net worth is exactly the same.
Using a mortgage is essentially the same except you get a $500,000 house asset but also get a $500,000 mortgage liability. Again, your net worth doesn’t change.
If you have purchase costs, like fees or taxes, these do reduce your net worth. Why? Because after the purchase the house is still only worth $500,000, even if the cash you had to pay wast $530,000 because of $30,000 buying fees. In this case, your net worth just dropped by $30,000.
In the future, your house may go up in value. But by definiton the day you buy it, the market price is the price you paid for it.
If you’re every considering whether to rent or buy a home, it really helps to understand this point. On day one of buying a home your net assets reduce by all the transaction costs. This means, you have to recover all this value before you are break even versus renting.
Does understanding how net worth works really matter?
Don’t have sleepless nights over your net worth calculation. The basics of adding up the market value of everything you own and owe will get you 99% of the way to the right answer.
But understanding the dynamics helps you realise what your financial freedom goal really is.
You are trying to maximise the additions and upwards revaluations to your net worth, whilst minimising the reductions and downwards valuation. That means getting more cash flowing in, less cash flowing out, and putting as much cash as you have into assets that should revalue upwards over time.
Your net worth changes every day. But you want its trajectory to be pointing upwards over time if you ever want to be financially free.
What next?
Now, you understand how net worth should really be calculated it’s time to know your own net worth.