While scrolling through your news feed or any internet feed in general, you must have come across articles, blogs, and top 10 lists of people with the highest net worth. Forbes even follows and updates their rich list annually and ranks people.
But what is the obsession about this seemingly normal finance term?
Does Net Worth really mean what people tend to think it means? Is it the richness quotient?
Not just in the finance world, this term has gained traction as a measure of richness and net worth is the scale with which society measures the wealth of individuals.
In this article, we shall understand all the minuscule nuances associated with the term ‘Net Worth’.
Defining Net Worth
In the world of finance, net worth has a very straightforward definition. It is a measure of the difference between the assets that one owns and the liabilities that make up the cumulative debt.
If you want to know if you are building up your wealth, you will realize that the net sum is positive when you go through your personal balance sheet. The positive value indicates that your Net Worth is currently positive and that you’re actually in the process of accumulating wealth.
Now that your net worth is positive, can you start relaxing? Should you start planning your early retirement?
Not so soon! Net Worth is a highly subjective definition. Not only does it have no formal definition, there’s no exact meaning associated with it as well. A person earning 10x than you could still have a net worth that is less than you if that person’s spending habits are bad. On the contrary, a person earning an average paycheck could amass immense wealth by making use of fundamental financial principles such as systematic timely investments and the effect of exponential compounding with time.
When you check the ‘Net Worth’ of anyone including yourself, you are just witnessing the current status of the net assets’ appreciation and debt repayment condition. A better way to look at it is to think about the ‘Net Worth’ assessment as capturing the financial snapshot in time. It only portrays the approximate net value of a person’s balance sheet taking into account the real-time value of the assets, cash flows, and all the liabilities associated with that individual.
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Assets – All that you own
All the things that you entirely own, are all your assets. Just because you own something, doesn’t really mean that value of it stays exactly the same. The value of a piece of real estate that you bought has most likely increased in value, whereas the last estimate you got on your car is valued at less than fifty percent of what you paid for it just over a year ago!
Well, that’s the thing with Assets.
There are assets that depreciate like your car, and there are assets such as real estate which normally tend to appreciate. It is important to note that the exact contrary can be true as well. If you own a vintage car in perfect condition, the book value of such an asset, presented at the right auction, would fetch you millions whereas a piece of real estate that you bought during the peak of the market just before the global market sentiment decided to go against you, might incur you with a lot of potential unrealized losses.
These were tangible assets.
There’s another class of assets known as intangible assets. Intangible assets include investments, savings accounts, and retirement funds. These are equally important to your net worth. When valuing them, you need to consider their current market or face value. Investments, like stocks and bonds, fluctuate by the second as well, so remember that your net worth isn’t set in stone.
The process of valuing the assets is usually done by experts in that particular field. This fact should enlighten you into thinking of Net Worth as something dynamic and fluid with no specific significance across longer timespans.
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Liabilities – All that you owe
Liabilities are the financial responsibilities you owe to others, and understanding them is just as important as knowing your assets when it comes to calculating your net worth. So what could liabilities comprise off of? Let’s understand the role of liabilities, how they interact with your net worth, and the factors that you need to keep in mind while thinking of liabilities in this section.
- Types of Liabilities: The most common forms of liabilities include mortgages, car loans, student loans, and credit card debt. Each of these has its own terms, interest rates, and impact on your net worth.
- Interest Rates and Terms: It’s essential to know what the interest rates are and the repayment terms for each of the debt forms that you possess. High-interest loans or credit card debt can weigh you down, while low-interest loans may be more manageable. Understanding these factors helps you make wise decisions about which liabilities to prioritize paying off.
- Tracking and Managing Debt: Liabilities aren’t necessarily a bad thing, but they can burden you if you do not manage them wisely. Keeping track of your outstanding debts, due dates, and monthly payments is critical. Budgeting and planning can help ensure you’re on top of your debt obligations and steadily reducing them which indirectly equates to increasing your net worth.
- Good Debt vs. Bad Debt: Not all debts are created equal. Some debts, like a mortgage used to buy a home or a student loan invested in education, can be considered “good debt” because they have the potential to increase your net worth in the long run. “Bad debt” is typically associated with high-interest consumer loans, like credit card debt, which can erode your net worth if left unchecked.
- The Liability Side of the Equation: When calculating your net worth, remember that liabilities are subtracted from your assets. Basically, they represent the financial claims others have on your assets. So, by reducing your liabilities, you are increasing your net worth significantly.
Building Net Worth
Elon Musk currently has the highest net worth compared to anybody else in the world right now. If you are worried that you have to be a genius in order to increase your financial quotient, don’t worry. That’s not at all the case. You can increase your wealth in an organized manner. If you can control your dopamine with respect to lavish spending and undertake saving prudently, you too can build your net worth by being financially disciplined.
