Before we begin, if you’re reading this in your email and see “Anonymous” as the author, that’s due to a system issue I’m working to resolve. Until then, please understand that it’s still just me…
Here are three more finance terms from the YouGov poll we’ve been reviewing in recent weeks: Assets, Liabilities, and Net Worth. These terms are so fundamental that they can be easily overlooked. But as with most financial jargon, ignorance is not bliss and misunderstanding these terms can cause you all sorts of problems.
Here are my brief definitions for each, understanding that the actual definitions go well beyond what I make room for in these posts. For example, we can think of our personal relationships or education as “assets”, but let’s stick to definitions from the realm of personal finance.
Assets – Think about assets as the physical stuff we own that could be sold for cash reasonably fast. But while you could sell literally everything you own and walk away with cash and the shirt on your back, how likely is that? Not very, so we tend to think about the value of more specific assets, such as the home we own, our car, investment accounts, maybe collectibles like artwork, jewelry, guitars, or even Beanie Babies (hey, they’re worth a lot these days…).
Where do the values come from? The internet makes it easy to value most assets. While it’s an imperfect tool, I like to use the “Zestimate” from Zillow for home values. Bank and investment account values can come from each company’s website, so that’s straightforward. But how to value the antique Hummel figurines left to you by your great-aunt? The internet can probably assist there too. Remember, we’re trying to value what our assets would likely sell for now, so go with the best number available.
List your assets and the current or expected rate of return for each. If the rate of return is too hard to quantify, instead list whether the asset is expected to appreciate or depreciate. Then total up the values and make note of the amount on a piece of paper.
Liabilities – Your liabilities are simply the amounts you owe to others; your debts. While you might owe small amounts of cash to friends and family, we’re primarily focused on the amounts you borrow from banks and other entities.
Your list of liabilities will include the principal amount still owed on your mortgage, your car loan, student loan, and any credit card balances or other debts like the solar system you had installed last year. Ideally your liabilities would have low interest expenses and be at a fixed rate. It’s important to know your interest expense because it soaks up cash and keeps you from adding to your assets.
List each liability with its corresponding interest rate and whether it’s fixed or variable. Total up your liabilities and subtract this number from your total assets to get your…
Net Worth – Your net worth is the difference between your assets and your liabilities, nothing more complicated than that. But it’s an important number because it tells you how you’re doing financially, especially when monitored over time.
As you can imagine, the ideal situation is to have a positive net worth, meaning you own more than you owe. If this is you, congratulations! To keep it that way and improve over time, make a concerted effort to borrow only when necessary and to keep purchases of depreciating assets (like cars) to a minimum. This should keep your assets growing in value and in proportion to your liabilities as you pay down remaining debt.
You could find, however, that your net worth is negative. Does that make you a bad person? No, but it’s something to understand and pay attention to. It could mean you’re just starting out in your financial life and have borrowed before you’ve had much of a chance to earn and save. It could also mean you’ve overborrowed, perhaps from credit cards and car loans, maybe old student loans, and you need to tone down spending to pay down debt faster.
Monitoring your net worth and how it changes over time is helpful when thinking about debt-based purchases. For example: Is the purchase your contemplating likely to increase your net worth over time or decrease it? The former usually implies an investment decision (either in real estate, stocks and bonds, or perhaps in your own earning potential) while the latter should generally be avoided unless necessary.
Here’s an example of taking a net worth hit that could wind up being a good investment over time. Say you want to go back to school and finish your college degree, which could help you get you a better-paying job. You need a couple years’ worth of classes and the total cost could be, say, $25,000. If you borrowed the tuition money your net worth would take a hit because you’re adding a liability. But in the long run you’d potentially be earning more money and could pay down the debt faster which would improve your net worth. Your higher income could eventually allow more savings as well, which would also grow your net worth. Sometimes you have to take a step back to take multiple steps forward.
Here’s a link to the YouGov information if you’re interested:
Have questions? Ask me. I can help.
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