Keeping track of your net worth can help you be better with money: Here’s how
You can not only calculate your net worth, but keeping track of it can help your finances
Dubai: You may have heard of net worth being calculated for either millionaires or billionaires, but did you know that you can not only calculate your net worth, but also how keeping track of it can actually help your spending? Here’s how.
Your net worth is simply an accurate snapshot of your financial situation and is a single number that shows the value of everything you own, minus how much you owe. In technical terms, it’s the sum of the value of your assets after deducting the value of your liabilities.
What are assets? Assets include pretty much anything you own or anything you’ve invested in that generates income. That could mean cash, bank accounts, investment accounts, home value, collectibles, real estate, stocks, bonds, and even cryptocurrencies, among others.
Why is knowing your net worth important?
“Knowing your net worth is important because it can help you identify areas where you spend too much money,” explained Mohammad Shaan, a Dubai-based wealth manager who became full-time advisor recently.
“Just because you can afford something doesn't mean you have to buy it. To keep debt from accumulating unnecessarily, consider if something is a need or a want before you make a purchase. This is the real reason why knowing net worth matters to your personal finances.”
So while we need funds for our day-to-day life, keeping provision for unexpected expenses is also a must. This is when your net worth provides for you, wherein funds are kept as cash or in such investments that can be converted into cash immediately in times of need.
• List your liabilities (what you owe) and add up the outstanding balances.
• Subtract your liabilities from your assets to determine your personal net worth.
Let’s now break it down further into these two steps on how you can calculate your net worth:
Step #1: Calculate how much assets, debt you have
When calculating your assets, you need to measure liquidity of your assets i.e. possessions you could exchange for cash. “Some assets are more liquid than others, meaning you could sell them more rapidly at a price that reflects their current value,” explained Shaan.
Cash, for instance, is the most liquid asset. But other assets are less liquid, which means it would take time to sell them, and you might not get exactly what you thought they were worth. When it comes to your liabilities, which are the debts that you owe, you need to break it down further.
“Over time, some liabilities slowly transform into assets as you pay off your mortgage and earn equity in your home. In other cases, paying off a liability means you have no further obligation to the entity that lent you money, like working down your credit card balance,” he added.
Step #2: Calculate annual asset, liability growth rate
The annual growth rate is the percentage growth of your investment divided by the number of years you stay invested. It can be very tricky to get right because tabulating the value of real estate, personal property, investments and cash, will most likely earn a very different annual rate of return.
Meanwhile, the average annual rate you expect your liabilities to increase (or decrease if negative) in value is how you calculate liability growth rate. Calculating such rates could be complex because of the varied kinds of investments and debts there are.
For instance, some liabilities, like a car loan or a home loan, have set terms and rates of interest that you’ve already agreed to. On the other hand, other liabilities like student loans and credit card debt, are more unrestricted and fluid. If you keep adding more to your balance, or make only minimal regular payments, these liabilities of yours will continue to grow.
What if you have student loans or credit card debt that you’re not paying down regularly? How would you then calculate it? You can then make a rough estimate of what your liability growth rate might look like based on the interest rates and balances you hold.
“When measuring asset growth, assume a default growth rate of 7 per cent to reflect somewhat conservative returns for stock-heavy investments and real estate. You may wish to lower the rate if you have substantial holdings in cash or personal property with low or no rates of return,” he added.
Why is net worth important? Here are two illustrations to prove
Scenario #1:
You’ve been working full-time for just under a year at your first job, and you managed to save a total of Dh6,000. However, you still owe Dh25,000 in education loans, which is regularly being paid off at Dh1,000 per month.
• Your assets: Dh6,000 cash savings
• Your liabilities: Dh25,000 student loans
• Your net worth: -Dh15,000
Here’s what Naish recommends: “By seeing that your total net worth is actually negative, your priorities are pretty clear over the next two years till your loan is being paid off. You’re probably most focused on your job that allows you to save for retirement while paying off your student loans.”
Scenario #2:
You are a homeowner. Your home is worth Dh350,000 in the current market. You have Dh250,000 left to pay on your mortgage, and you have a credit card balance of Dh10,000. Your mortgage has an APR of 3.25 per cent and your credit card charges 19.99 per cent.
You want to sell your house, but it needs repairs. You have Dh10,000 in cash savings and Dh30,000 in retirement fund. Your income is enough to pay all your bills, and you have a bit of cash left over each month.
• Your assets: Dh10,000 savings; home valued at Dh350,000; Dh30,000 in retirement fund
• Your liabilities: Dh10,000 credit card balance; Dh250,000 mortgage
• Your net worth: Dh130,000
The above net worth calculation is not as straightforward as the first. There are many factors at play, including the value of the house and whether or not an owner can sell it for what it’s worth. Housing valuations change all the time. Likewise, the balance of your retirement fund can fluctuate overnight based on the stock market.
The above homeowner has some choices to face: If they want to grow their net worth, should they invest in renovations to make their house more valuable? Or should they pay down their high-interest credit card first? Here’s what Naish recommends doing:
“Since the interest on their credit card is so high, it may be wise to knock that out using a portion of their Dh10,000 savings, especially since they could use their left over cash every month to rebuild their savings.”
Net worth doesn’t depend so much on the size of your income but more on how you use it also makes it a helpful tool for comparing people’s financial states
Bottom-line?
Simply put, the key takeaway is that calculating and tracking net worth is proven to be vital giving you a sense of the health of your personal finances.
“If your assets outweigh your liabilities, you’re probably doing well financially. But if your liabilities outweigh your assets, you should work on reducing debt,” added Shaan.
“The fact that net worth doesn’t depend so much on the size of your income but more on how you use it also makes it a helpful tool for comparing people’s financial states.”
You might believe that a person earning a high salary is better off financially than someone who makes a relatively modest one. But the better comparison would be each person’s net worth.
After all, a high salaried individual might have greater debts that actually gave them a lesser net worth than someone with less means who uses what they have more judiciously.