What is net worth?
In its simplest terms, your net worth is the difference between what you own and what you owe. What you own are your assets, and what you owe are your liabilities. This simple calculation helps banks and creditors determine your financial worthiness. If you want to get a car loan or buy a house, this is a critical figure to know.
Suppose you own a bike that’s worth $2,000 and you have a savings of $12,000 for this year. You also have a student loan of $10,000. Your total assets are $14,000 while your total liability is $10,000. It means that you have a net worth of $4,000.
Your net worth can increase if you increase your assets or decrease your liabilities. You should aim to consistently improve your net worth because this is a good sign of financial health. On the other hand, if your debts increase relative to your assets, your net worth will decrease. It’s good to recalculate your net value at least once a year to know your financial health and give you an idea where you are in your financial goals.
Factors affecting net worth
One of the difficulties in knowing your net worth is assigning the correct value to your assets. Make sure to put a conservative estimate of the value of your assets to avoid an unrealistic view of your wealth. Here are a few things to consider:
1. Assets may fluctuate in value. You have to remember that the value of your asset will not remain where it is. The value of your bike depreciates every year as it gets older and new models come out. If you have a long-term investment portfolio, it can also fluctuate in value based on the market.
2. You can have a lot of assets like a huge house and a fancy car yet have a low net worth because you owe a lot of money on it. Similarly, you can have a modest home and car but have a high net worth because you don’t owe a lot of money.
3. It is normal for net worth to rise and fall, but the overall trend is what’s important. Ideally, you should strive to increase your net worth as you grow older. This means paying your debts, acquiring equity in your home and acquiring more assets.
Why is it important to know your net worth?
Knowing how to calculate and monitor your net worth is a fundamental tool in financial literacy that you should understand. When you see your finances in black and white, you’re forced to face the realities of where you are regarding your wealth or lack of it. Armed with this knowledge, you will have a better idea as to whether your current path leads to success, or if you need to make changes in your habits.
Your net worth will also tell you if you need to adjust your spending. Just because you can afford a new car doesn’t mean you have to get one. Your needs, rather than your wants, must make up the majority of your expenses to prevent too much debt.
It can also serve as a wake-up call to get you back on track. Reviewing your assets and liabilities can help you come up with a sound plan to pay existing debts. For example, if you are earning 1.45% interest on a savings account, but are also paying 12% on your credit card. It might make more sense to use your cash to pay your credit card instead.
The bottom line is, knowing your financial health through a regular review of your net worth will help you plan your future regardless of where you are now.