FI Step by Step: Step 2, Where Am I Now? Determining Your Net Worth

Step 2: Where Am I Now? Determining Your Net Worth

Now that you have defined why you want to embark on this journey, the next step is to determine where you are now, your starting point.  In the world of personal finance, that means determining your net worth.  Net worth is a cumulative measure of what is most important in your financial life, and is critical on your path to FI.  By tracking your net worth you can consistently measure your progress as you work towards your financial goals.  

Your net worth is the true measure of your wealth.  This is a new concept to many people.  The media would often have you believe that the measure of wealth is your annual income.  Common phrases you will hear are “the top 10 percent” or the “top 1 percent.”  This typically refers to how much money you earn in a year.  So you may think that if you earn enough to be in the top 10 percent or the top 1 percent, you must be wealthy.  But the true measure of wealth is not how much you earn, but how much you save.  What matters is what you have to show for your earnings at the end of the day.  This is why people with high incomes can actually be broke, and people with average or low incomes can be quite wealthy with consistent disciplined saving and investing over time.  No matter how much money you earn, you can always spend more.  We have all heard of professional athletes and celebrities that have made millions and millions of dollars and squandered it all, only to declare bankruptcy a few years later.  

The true measure of wealth is not how much you earn, but how much you save.

Another common misconception is that a big home, fancy cars, nice clothes, or exotic vacations mean you are wealthy.  Most of us, at least subconsciously, fall into this way of thinking.  When we see someone driving a luxury foreign car or buy a 10,000 square foot home, we automatically think “oh, they must be rich.”  While some of these individuals certainly do have a high net worth and are wealthy, there are many who do not.  High consumption does NOT equal wealth. Many people with these luxury items have purchased them on credit and are living paycheck to paycheck to support this exorbitant lifestyle.  These concepts are discussed in great detail in one of my favorite personal finance books, The Millionaire Next Door, by Thomas J. Stanley, Ph.D. and William D. Danko, Ph.D.  In their bestselling book they report the spending habits and lifestyles of the thousands of true millionaires (those with a net worth of $1,000,000 or more) that they surveyed.  Most of these millionaires were self-made first generation wealthy individuals that live modest lifestyles,  drive modest cars, have never spent more than a few hundred dollars on a watch, and have very high savings rates.  

I think the best analogy for monitoring your net worth is tracking your weight as a measure of improving your health or weight loss.  Most people in America have tried to lose weight at some point.  The most common way to track your progress is to step on the scale on a regular basis.  The number you see, your weight, is a cumulative measure of how much food you are taking in, balanced with how much physical activity or exercise you are doing.  Likewise, your net worth is a cumulative measure of everything you own of value (your assets) minus everything that you owe to others (your liabilities).  Our weight will typically go up or down a small amount day to day, even when we are trying to eat less and exercise more.  This is largely due to fluctuations in water content in our body from day to day.  But when measured over longer periods of time (weeks and months), our weight is an excellent measure of our actual progress when the goal is to lose weight.  Similarly, our net worth may fluctuate quite a bit day to day due to the volatility of the market.  But when tracked over long periods of time, our net worth is the best indicator of our financial health and how we are progressing.  

Determining your net worth for the first time can be a very scary or painful thing.  Just like many people don’t want to step on a scale and see their weight, many don’t want to know their true financial situation, especially if they have a significant amount of debt.  It is easier to live in ignorance than to be faced with the reality of where you really are financially.  It can be very scary to realize you have a negative net worth, meaning you owe more than you even have.  How can I ever pay off my debts?  How can I pay for my kids’ college?  Will I ever be able to retire?  

I am here to tell you that these feelings are natural and it is time to push past them and move forward.  You can’t start developing a financial plan with goals for your future until you have a firm grasp on your current financial situation.  There is a quote from Vicki Robbins that she applies for this situation in her book, Your Money or Your Life.  When facing some of these difficult truths she uses the mantra, “No shame, no blame.”  Your financial decisions have not been perfect to this point, no one’s have.  But there is no point in wallowing in them or losing sleep about it, it is in the past and it is time to move forward.  This is a new chapter in your life.  You are becoming financially literate and beginning the journey toward financial independence.  

For some, calculating your net worth may be a welcome surprise if you have already done some saving and investing.  For a select few, you may have already been tracking your net worth on a regular basis.  To these individuals I would say keep up the good work and let’s find areas you can do a little better.

As explained in my post, The Basics of FI, your net worth is determined by adding up all of your assets and then subtracting your liabilities.  There are 3 basic ways you can do this.  

1. Good old pencil and paper
2. Use a spreadsheet
3. Use an app, like Mint or Personal Capital

I personally like using one of the apps for several reasons.  First, if you link one of these apps to all of your pertinent financial accounts, not only can you determine your net worth now, but it will update automatically as your balances change in the future.  This will allow you to easily track how your net worth changes (hopefully in the positive direction) over time.  If you choose to track it by hand or enter it into a spreadsheet, you will have to update it on your own manually.  What do you think is the likelihood that you will continue to diligently update all of your accounts over time?  I didn’t think so.  Second, the apps put all of your financial information in a very nice, easy to understand format with charts and graphs breaking things down for you.  This helps you better understand what is happening with your money and where you can potentially improve things.  Finally, there are other steps, such as tracking your expenses and budgeting, that we will be tackling in subsequent steps on the path to FI; these apps will help a great deal in these parts of the process as well.  So which app do I use?  I’ve used both extensively.  I think Mint is better when you are getting started with personal finance and your primary focuses are getting out of debt, tracking expenses, and budgeting (check out my review of Mint here).  I think Personal Capital is better when you are more focused on investing accounts, asset allocation, and investment fee tracking (check out my review of Personal Capital here).

Whichever method you choose is up to you, but as you can tell I highly recommend using one of the apps.  One major concern people have is security when they are entering their username and passwords for their financial accounts on third party software.  I had the same concern initially as well.  However, I have used Mint for several years and Personal Capital for nearly a year and have never had any issues.  Millions of people use these apps as well.  So, while I obviously can’t guarantee there will never be a security breach, I think it is pretty safe.  Plus, if you are monitoring your accounts on a regular basis, you will likely pick up any fraudulent activity pretty quick and can correct it.

So, back to the basics of calculating net worth.  Let’s start with your assets, which is anything you have of value and could sell for money.  Generally, balances or values of the following Items should be listed under your asset column:

• Checking accounts
• Savings accounts
• Retirement accounts (401k, 403b, 457b, Roth IRAs, other IRAs, etc.)
• College savings accounts (529 plans)
• Taxable brokerage accounts
• Real estate investments
• Cash value of any permanent life insurance
• Other notable assets (fine art, valuable collectibles, etc.)
• Primary residence if you own a home
• Vehicles

Some of these items are debatable.  For example, Robert Kiyosaki, in his book Rich Dad Poor Dad, defines an asset as anything that puts money into your pocket.  For this reason, he does not consider your home an asset since it costs you money in the form of property taxes, home insurance, and regular maintenance.  Likewise, vehicles cost you money in the form of auto insurance, registration fees, and maintenance.  Furthermore, they depreciate (go down in value over time).  However, when determining your total net worth, I tend to include these items for two reasons.  First, they could be sold for money.  Second, they do hold significant value.  You can get a relatively accurate estimate of your home’s value based on how much you pay in property tax each year.  The value of your vehicles can be estimated by using the Kelley Blue Book.  I do not, however, include your home or vehicles when determining available assets to achieve financial independence, since they don’t produce income.  

When adding up your assets, I would not recommend including consumption items of lesser value such as TVs, computers, appliances, furniture, etc. for a few different reasons.  First, it’s very time consuming to list all these items and try to figure out what they are worth; I don’t feel it’s time well spent.  Second, how do you really calculate their actual current value, meaning how much money someone might give you for it today?  If you bought that TV for $1000 three years ago, I guarantee no one will give you that much for it now.  How much you could actually sell it for is just a guess and likely very dependent on its condition and the buyer.  Finally, where do you draw the line?  Do you count everything over $1000?  $100?  Do you try and assign value to everything you own?  We are really looking for the bigger picture here, not an exact estimate of how much the junk you have accumulated over time is worth.  

Once you have determined what your assets are, you can link theses accounts to one of the apps.  For assets that don’t have an online account, such as your home or real estate investments, you will have to assign a value and enter it manually in the app, which can be done pretty easily.  The other option of course is to record your balances with a spreadsheet or pencil and paper.  Once everything is entered or recorded, add it all up and you have a total value of all your assets.  The apps will do this automatically.

Next, you need to determine your liabilities, which is money you owe to others.  Items that should be listed under your liabilities generally include:

• Credit card debt
• Other consumer debt (money owed on furniture, appliances, etc.)
• Student loans
• Medical bills
• Auto loans
• Home mortgage
• Home equity loans
• Mortgages on real estate investments
• Any other debts

If you are using one of the apps, you can link nearly all of these accounts as well.  For those that may not link up directly, you can enter the information manually.  Please note that any account you enter manually will also have to be updated manually.  If you are tallying up everything on your own, go ahead and make a separate list of your liabilities and add up the total amount.  The app will do this automatically for you.

Now it is time for the moment of truth.  Go ahead and subtract your liabilities from your assets and you will have your net worth.  If you are using one of the apps, this is calculated for you automatically.  For many, this may be a negative number, which means you owe more than you have.  While it may feel hopeless or scary, this is actually a good thing, because now you know where you stand.  When I first came out of training, I had a significant negative net worth as well, largely due to student loans.  Once you know where you are now, you can begin formulating a plan to improve your position.  If your net worth is positive, then give yourself a little pat on the back and start thinking about ways to increase it.

So, what do you do now with this information, with this number?  Just like tracking the number on the scale when trying to lose weight, you can now regularly track your financial health and progress towards your goals.  But how often should you track your net worth?  I think that may be a little different for everyone.  Obviously for those using one of the apps, this is much easier to do.  You open up the program on your smartphone, tablet, or internet browser, your accounts take a minute or two to update, and your current net worth is recalculated.  For those using pencil and paper or a spreadsheet, you’ll have to log in to each of your accounts individually, get the updated balance, and recalculate everything manually.  I check my net worth every day because I love personal finance and I like to stay on top of things.  But I understand that my net worth will fluctuate based on recent market performance, just like your weight fluctuates on a day to day basis. So I don’t freak out when I lose a few hundred dollars or even tens of thousands of dollars in a single day due to normal market volatility.  I am invested for the long term and steadfast in my financial plan, so even in the worst bear market I am confident I will not lose my nerve and sell.  However, for many this not the case and it may be unhealthy or unwise to check their net worth every single day.  Whatever interval is right for you, the principle here is that you need to check your net worth regularly in order to track your progress towards your goals.  

One final point I would like to make is that your net worth and your FI number are usually different.  Remember that your FI number is the amount you need to save to become financially independent, which is typically estimated at 25 times your annual expenses.  The reason these values are typically different is that most people usually include the equity in their home, and often the value of their vehicles, when calculating net worth.  That is what I do, too.  However, when calculating your progress toward your FI number, it makes more sense to only include cash and income generating investments, such as stocks, bonds, real estate investments, and other forms of passive income.  Because your home and cars do not generate income, and you still need a place to live and transportation after you reach FI, it doesn’t make good sense to include these items as part of your FI number.  

Congratulations on completing another step toward becoming financially independent.  This is a very important step and a wake up call for many.  I’d recommend you record your initial net worth and the date, because some day you will look back at this and marvel at how far you have come.  In Step 3: How Did I Get Here? Tracking Your Income and Expenses, we will begin to better understand the road that lead you to where you are today.