Personal finance has never been more complicated. The typical family has to make a host of decisions ranging from retirement investing to paying down debt to buying insurance. And that says nothing of credit scores, emergency funds, 529 plans, and HSAs.
Among this complexity, however, is a simple way to measure financial progress. It's a number that every business large and small tracks. It's also a number that millionaires and billionaires track. It's easy to calculate, and everybody should know their number. What's the number? Your net worth.
The calculation is easy. Net worth is nothing more than total assets (what you own) minus total liabilities (what you owe). These assets and liabilities are typically listed on a balance sheet, sometimes called a personal financial statement. We can even simplify the net worth calculation further.
Rather than capture literally everything that you own, include only assets that go up in value. For most this would include cash, retirement investments, taxable investments, and real estate. Don't fuss with personal property, cars, boats, or other assets that eventually become worthless.
Why is your net worth so important? It's simple. Net worth represents the sum total of every financial decision we've ever made throughout our entire lives. A bold statement, to be sure. But it's true.
When we spend less than we make, the difference ends up on our balance sheet. It may take the form of additional emergency funds savings, investments in an IRA, or perhaps a decrease in our student loans or credit card debt. Either way our net worth goes up.
When we spend more than we make, this too is reflected in our net worth. It may take the form of a decrease in savings, or more likely, an increase in our total credit card debt. Either way our net worth goes down.
Investment gains and losses also affect our net worth. When we start out with little invested, net worth is all about how much we save. As our net worth grows, however, it becomes more about investment returns thanks to the magic of compounding.
This is true even for billionaires. Warren Buffett's net worth changes from year to year based on the performance of Berkshire Hathaway, not his $100,000 a year salary.
Back to reality. Let's look at some everyday decisions we make that affect our net worth.
- Credit Scores: You work hard to improve your credit score. With a higher FICO score, you are able to refinance your mortgage to a lower interest rate. This results in a lower monthly payment and less money spent on interest. The money saved increases your net worth.
- Credit Card Debt: You take advantage of a 0 percent credit card to reduce the interest you pay on your credit card debt. The result is the monthly payment goes entirely to principal, not interest, reducing the liability faster than if you hadn't transferred the debt. Your net worth rises.
- Investing Costs: You switch from high cost actively managed mutual funds to low cost index funds. The change decreases your investment costs by one percent or more each year, increasing the investment returns you get to keep. Your net worth rises.
Net worth is the ultimate financial score card. Tracking net worth over time and evaluating the changes from year to year is the single best way to monitor your progress. It can easily be tracked in a spreadsheet or in a free online tool such as Personal Capital.
However you track your net worth, make it a priority in 2016.