Four Steps for Calculating Your Net Worth
Calculating your net worth: an analogy
To understand the importance of calculating your net worth, let’s look into a little bit of history.
In the 1920s, research was conducted at the Hawthorne Works electrical plant outside Chicago. The research demonstrated that workers would increase their productivity for a short time during a period of direct observation, but that would decline after the observation period ended. Later dubbed the Hawthorne Effect, this research gave credence to the notion that “the act of observing a phenomenon changes that phenomenon.”
The concept promoted by this experiment is that if a subject is aware that they are being observed, they alter their behavior in response to that observation.
The effects of this are readily apparent in everyday life. When we are dating someone, we may change our speech patterns or topics of conversation. If we are getting dressed for an interview, we may pick out a different set of clothes after looking at ourselves in a mirror. When dieting, it is important to weigh yourself regularly so you have feedback on your progress towards your weight loss goal. This effect is temporary and tends to decline after the observation period ends.
You need to have regular reports on your investments and debt elimination plans so you can change your behaviors to meet your goals. By tracking where your money is and how it grows, you force yourself to think actively about your saving and investing habits. This in turn makes you frequently reassess your finance plan. The practical application of this is to track your net worth on a regular basis, at least once or twice per year.
How do you go about calculating your net worth?
Your net worth is defined as your total assets minus your total liabilities. In other words, it’s what you own minus what you owe.
In calculating your net worth, you should include your assets and liabilities. Include your house, IRA, 401(k), cash, investments, real estate, and any other major assets like art or expensive jewelry that you might sell one day. You should also include totals of loans and debts.
I personally don’t include items like cars or furniture that are items of consumption. You can include those if you want, but every time you sell one of those items, it drops your net worth because the item will be worth less than when you bought it.
I also don’t include money that I am saving for a future purchase, such as a car. If I have $10,000 in a savings account for a future car purchase, I don’t include it because I consider that money “pre-spent.” I’d rather not see my net worth drop at the time I spend that money, so I just don’t include those items.
Example for calculating your net worth
Home value: $300,000 Car loan: $15,000
IRA: $50,000 Student loans: $150,000
401(k): $70,000 Mortgage: $200,000
Cash: $15,000 Credit Card: $25,000
Total Assets: $435,000 Total Liabilities: $390,000
Net worth: $435,000 – $390,000 = $45,000
After calculating your net worth, then what?
You need to use that information to modify your spending, saving, and investment patterns to achieve your goals. If your net worth hasn’t gone up substantially in the last year, then you need to be saving more for retirement or paying down debt more aggressively. Let’s look at a practical, step-by-step approach to using this information.
If you don’t know where you want to go, how will you know when you’ve arrived? You and your spouse should set some financial goals for your family. What goals you set will be different based on your personal situation, but here are some questions to answer that can help you set some realistic goals.
- When do I want to be free of consumer debt (e.g., student loans, credit cards, car loans)?
- How old do I want to be when my net worth reaches $1 million?
- How long until my kids are ready for college, and how much will I need to save by then?
- When do I want to have a paid-for house?
- At what age do I want to retire?
Once you have your goals in mind, it’s a simple enough exercise to pull up any of a hundred savings calculators online to calculate how much you need to save monthly in order to reach those goals. You can get more information on this step by downloading my free guide to setting reachable financial goals.
Step 2: Calculating your net worth monthly for 1 year
Get in the habit of calculating your net worth on a monthly basis. Eventually, you may find that you only want to be calculating your net worth a few times per year. At the beginning, there’s real value in frequently assessing your progress. You can use that information to adjust your spending and savings to ensure you are progressing towards your goals.
Once you’ve been calculating your net worth for a full year, you’ll be able to see a clear trend in your finances. I still calculate my net worth on a monthly basis. It helps me keep my spending in check and not get sidetracked by impulse purchases, knowing that I’m steadily making progress.
Step 3: Use your net worth calculation to achieve your financial goals
Once you start calculating your net worth and can see a trend over a few months, you’ll know if you’re on track to meet your goals.
Has your net worth declined three months in a row because you’re paying exactly the minimum payments on all your loans and racking up more debt on the side? Or, are you seeing an increase in your net worth due to savvy savings and reduced consumer spending?
It’s easy to say, “I think my diet is working.” But, it’s another thing to see your actual weight on the scale or observe yourself in a mirror. Don’t allow that truth to guilt or shame you. Use it to motivate yourself! This is all about finding ways to help you achieve your goals.
****Advanced tip: save a receipt from every purchase for several months. Calculate how your money was actually spent and use that to make changes to your budget.****
Step 4: Reassess your financial plans at least once a year
At least once or twice a year, you should sit down and review your current net worth and look at your overall financial goals. Are you on track?
Have your goals changed since the last time you looked at them? Maybe you’ve recently gotten married, had a child, or changed jobs. All of those things can and should affect how you plan your financial future. Don’t be afraid to set new goals periodically. Use the data you’ve collected to determine whether you are meeting your goals.
Remember, the act of observing a phenomenon changes the phenomenon. Sit down this week with your spouse, set some financial goals, and calculate your net worth.
Just like budgeting, get in the habit of calculating your net worth every month. Then, use that information to guide your monthly budgeting and regular spending and saving habits.
I encourage you to use the net worth information for motivation. After you have tracked it for a while, it’s fun to look back at prior years’ data and see just how far you’ve come. The effects may be slow at first, but just wait until you see the net worth graph start to climb. It’s a lot of fun!
Leave a comment below and let us know what questions you have with regard to calculating your net worth.
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