You may have heard the term “net worth” come up from time to time. It is a bit jargon-y, but it is a big thing in both the worlds of business and personal finance. Somehow adding “net” in front of anything (or “gross” for that matter) always makes it more confusing. At least to me. And I have an MBA. So… don’t tell my teachers or they might revoke my diploma.
Anyhow, today I’ll explain what net worth is within a personal finance context. I’ll talk about how you calculate it (spoiler: there is a lot of disagreement about what should be included in net worth) and also why you should even bother to think about your net worth at all.
Net worth is arithmetic: assets minus liabilities
At the simplest level, net worth is a calculation of all of your assets less all of your liabilities. Your assets include anything you own. Typically, you include only long term assets. What does this mean? That new leather jacket you bought for $500 is probably not an asset. If, however, you purchased a leather jacket that is a collector’s item and could be re-sold in the future for more money, you could potentially consider that an asset.
This is where the gray area of what should and should not be included in net worth comes in. There is consensus in the world of personal finance that checking, savings and retirement account balances belong in a net worth calculation, but that might be where the agreed upon list ends. Some people include cars, some don’t. Some people include houses, some don’t. Some people even include their “individual capital,” which is essentially future earning potential based on skills you possess. You can see how this gets fuzzy pretty quickly.
The liabilities side of the equation is somewhat clearer. Liabilities are essentially debts: anything that you owe another person or institution. This includes student loans, car loans, mortgage loans, etc. The liabilities included in your net worth should tie to the assets. For example, if you include the value of your car as an asset, include the value of your car loan as a liability. The same goes for a home and a mortgage.
Here is a quick summary table of assets and liabilities that should always or sometimes be include in net worth.
A Quick Example
Let’s do a simple example to illustrate how a (theoretical) person might calculate their net worth. Let’s look at a 20-something professional who rents an apartment in New York, doesn’t have a car, and makes $65,000 per year. Their net worth might look something like this:
This example is a pretty simple calculation, as we don’t have to worry about guessing what a home or car’s current value is, or determining if that should be included in the first place. What is useful here is to see that you could easily think that this person is doing very well, having amassed $15,000 in assets. But, it is important to look at the full picture, and when you take into account what is owed in student loans and credit card balances, you get a very different picture. This is not to say that this person isn’t doing well, since they have a relatively modest net worth. It is only to say that you must look at both assets and liabilities to get the full picture.
It is also worth noting that salary actually has no bearing whatsoever on net worth. If you make tons of money but spend it all, your net worth is no better off than if you make a meager salary and live within your means.
Why is net worth a useful tool?
Now that I have taught you how to do subtraction (I know, I’m a really good teacher), you might be wondering why the heck you should care about net worth. Won’t it just be depressing to calculate my net worth? Won’t I just feel like I’m behind in life, like everyone else is doing better than I am?
Here’s the thing about net worth. It should really only be used as a tool to compare yourself to yourself. Looking at your net worth in comparison to another person’s net worth is futile. There are so many different situations and circumstances not reflected in net worth, not to mention the fact that everyone makes their own decision about what to include in net worth. (Note that this probably won’t stop you from comparing your net worth to others. It certainly hasn’t stopped me. Oops.)
Net worth is best used over time, so start today
Do the math and calculate where you are today, including whatever assets and liabilities feel right to you. It doesn’t really matter what you include here, just make sure to include the same things in the future (i.e. if you decide you don’t want to track your home value and mortgage, that’s fine, just don’t add it back in later or it will skew the picture).
Then, at some point in the future (maybe every three months, maybe every year), do the math again. This will help you see where you’ve been and where you’re going. Maybe this will tell a happy story of decreasing debts and increasing net worth. Maybe you’re still in school and it makes sense to take on more debt to finance your education. But maybe you’ll see that your net worth is decreasing without brining you real value, and this will help you see that you need to change. Whatever your story is, knowing the numbers and seeing the change can only help.
Do you track your net worth? What do you include in it? Why do you care about net worth?