Simply put, the net worth of an individual is the amount by which his assets exceeds his liabilities. In business terms, the net worth is also known as the book value.
Why does it matter? The net worth is the single most important number to estimate an investor’s ability to retire early. Income is important, the Savings Rate is important but they both contribute to the same goal : increasing the net worth.
Assets & liabilities
There are slightly different ways to calculate Net Worth and the version below is the most intuitive. Take a spreadsheet and list on one side all your assets. In that case, assets would be anything of value:
- Bank accounts (checking & savings),
- Certificates of Deposit (CDs),
- Company stocks,
- Brokerage account,
- Primary Residence’s market value*,
- Secondary Residences values.
I do not typically include lifestyle assets like cars, jewelry and such in my own calculations because they are not investable assets and because they don’t represent much anyway. It would also normally make no sense to build a net worth accumulating cars or jewelry so I typically exclude them from the assets list.
On the other side of your spreadsheet are the liabilities. Everything that represents “owed” money should be listed:
- Credit card debt,
- Student loan,
- Car loans,
- Primary Residence’s pending mortgage*,
- Secondary Residences mortgages.
* Note: including or excluding the primary residence in the asset/liability calculation is source of much debate but they both serve different purposes. For the individual investor, it does make sense to include the primary residence, however for the government, it is usually excluded.
Why you should include your house in your Net Worth
The house often represents one of the biggest investments someone will make and so it would make little sense to exclude it from the Net Worth calculation. If the house value increases on the market, so does the Net Worth. As the mortgage repayments progress, the liabilities decrease and the Net Worth increase.
I would include the primary residence value and pending mortgage in my Net Worth calculations.
However, strange things happen when someone transitions from being a renter to a home-owner: his net worth decreases and sometimes goes negative. Let’s look at Joe’s net worth while he is a renter:
- assets : 100k$ of savings
- liabilities: 0$
In this case, Joe’s net worth = 100 – 0 = 100k$
Now Joe decides to purchase a home worth 200k$, with a 4% mortgage over 30 years and a 20% downpayment. In total, this mortgage will cost 275k$.
- assets : 60k$ of savings + home value of 200k$
- liabilities: 275k$ of pending mortgage
Now, Joe’s net worth = 260-275 = -15k$
Joe’s decision to become a home-owner effectively reduces his net worth in the short term. Does it make sense to say that an owner has a lower net worth than a renter ? Or when taking an international perspective, does it make sense that an American home-owner has a lower net worth than an Ethiopian renter?
As such, to be able to compare net worth across individuals or countries, the primary residence is typically excluded from the calculations. In the eyes of the US government for example, a millionaire is someone with a net worth of at least 1M$, excluding its primary residence as explained by the Securities and Exchange Commission.
This is why it is OK to include your primary residence in your own calculations, as it provides a strong incentive to grow your net worth. However, when used to compare individuals’ net worth, the approach sometimes need to be tweaked to avoid bias.
Dear readers, do you calculate your net worth on a regular basis? What types of non-traditional assets do you include in your own calculations?
Nick – Money Miner
Photo credits: Oliver Berghold