Net Worth Definition
Net worth is the unencumbered value of your assets. In other words, it is the value of your assets minus the amount of debt (liabilities) you have.
Net Worth = Total Assets – Total Liabilities
It is what you would have left if you sold all your assets and paid off all your creditors. This is an important number to know since it provides you with a measure of your financial health. If you have more assets than you have debt, you have a positive net worth. However, if you have more debt than you have assets, your net worth is negative, and you will need to figure out ways to remedy the situation. This said, bear in mind that your net worth is just a snapshot of your financial position at a particular point in time. Thus, you may have a negative net worth one month due to an outstanding auto insurance bill, but a positive net worth the following month since this bill will have been paid.
An asset, in this context, is anything that you own that you can convert into cash. Obviously, the dollars in your wallet are already in the form of cash, but your checking and savings account balances are also readily converted into cash. Certificates of deposit also count, along with any investments you may have—stocks, bonds, mutual funds, annuities—whether held in a regular account or in a retirement account, such as an IRA or employer-sponsored 401k plan. If you happen to have a whole life insurance policy, include the cash value of it as well.
It is fairly easy to put a value on the assets listed above. It is just slightly more difficult to determine the market value of your home(s) or the vehicle(s) you own, but you can look at market values of comparable homes and use the blue book value of your vehicles to get good estimates. Alternatively, you can enlist the assistance of a realtor and a used car dealer to nail these numbers down. The fair market value of any furniture, electronics, good jewelry, and collectibles (such as that stamp collection your Uncle Oscar left you) is a bit more difficult to determine, but it is worth the effort. The important thing is not to overestimate the value of these possessions, lest you get a false impression of your true net worth.
“Liabilities” is just another term for debt. This includes any bills that are currently outstanding, such as medical, legal, insurance, or tuition bills. Credit card and other revolving credit balances must also be tallied up, along with other types of loans, such as student loans, car loans, and home mortgages. Since you receive regular statements from the various entities on the balances owed on each of these, no estimation is required for these amounts. They are what they are.
Net Worth Calculation
As an example, let’s take a look at Jeremy’s situation. Jeremy has $500 in cash, and the combined balances in his checking and savings accounts total $2,500. He also has a $1,000 U.S. government savings bond and $1,200 in a money market fund at a brokerage firm. He owns shares of the Vanguard S&P 500 Index mutual fund that have a current market value of $4,800, and the balance in his IRA is $10,000. He owns a condo with an estimated market value of $175,000. The current balance on the mortgage he used to finance the condo is $110,000. He also owns a Honda CRV that has a blue book value of $15,000. The loan he used to fund the purchase of it has been paid in full. He recently received a statement from his auto insurance company indicating that his six-month premium, in the amount of $400, is due in a couple of weeks. The combined balances on the two credit cards he owns is $800. The minimum payment due on each is $90. He has no other outstanding bills or loans.
To calculate Jeremy’s net worth, we first add up his assets:
Total assets = cash + checking/savings balances + U.S. government bond + money market fund + mutual fund + IRA + market value of condo + market value of automobile = $500 + $2,500 + $1,000 + $1,200 + $4,800 + $10,000 + $175,000 + $15,000 = $210,000
Next, we sum his liabilities. Notice that we use the entire credit card balances, not just the minimum monthly payment due.
Total liabilities = insurance bill + credit card balances + mortgage = $400 + $800 + $110,000 = $111,200
Jeremy’s net worth = Total assets – Total liabilities = $210,000 – $111,200 = $98,800
What does this mean?
Jeremy’s positive net worth means that he owns more than he owes—at least at this specific point in time. Lenders look at this number when deciding whether or not to lend someone money. It will be difficult, if not impossible, for an individual with a negative net worth to obtain a loan.
One takeaway on this: Let’s say you use your credit card to pay for almost all of your purchases, including groceries and gas, as well as airline tickets, major appliance purchases, and the like, because you enjoy a perk, such as cash back or airline miles. You always pay the entire balance due at the end of the month to avoid any interest charges, however. Before you apply to refinance that mortgage or for a loan to purchase a new vehicle, be sure to pay off those cards. Those high balances could result in a low, or even negative net worth, when your loan application is evaluated, causing your application to be rejected. Remember, the net worth calculation is as of a specific point in time.
So, what good is it then if this is the case? It’s the trend that is important. Ideally, your wealth should increase over time as you pay down the loans you used to acquire your assets. Unfortunately, some people end up spending more than their income allows, taking on more debt to do so, which, in turn, increases the amount of interest they owe, so they borrow even more to maintain their lifestyles, and, thus, the vicious circle continues. Calculating your net worth on a regular basis—perhaps once a month or once a quarter—will enable you to view your trend and make adjustments to your spending habits before they become a problem.