Your net worth is the amount by which your assets exceed your liabilities. In simple terms, net worth is the difference between what you own and what you owe. If your assets exceed your liabilities, you have a positive net worth. Conversely, if your liabilities are greater than your assets, you have a negative net worth.
Your net worth provides a snapshot of your financial situation at this point in time. If you calculate your net worth today, you will see the end result of everything you've earned and everything you've spent up until right now. While this figure is helpful - for example, it can provide a wake-up call if you are completely off track, or a "job-well-done" confirmation if you are doing well - tracking your net worth over time offers a more meaningful view of your finances. When calculated periodically, your net worth can be viewed as a financial report card that allows you to evaluate your current financial health and can help you figure out what you need to do in order to reach your financial goals.
Net Worth = Assets - Liabilities
Your assets are anything of value that you own that can be converted into cash. Examples include cash, real estate and personal property. Your liabilities, on the other hand, represent your debts, such as loans, mortgages, credit card debt, medical bills, utilities and student loans.
One of the challenges in calculating your net worth is assigning accurate values to all of your assets. It's important to make conservative estimates when placing value on certain assets in order to avoid inflating your net worth (i.e. having an unrealistic view of your wealth). Your home, for example, is probably your most valuable asset and can have a significant impact on your net worth. Determining an accurate value of your home, by comparing it to similar homes in your area that have recently been sold or by consulting with a qualified real estate professional, can help you calculate a realistic net worth.
What Does It Mean?
Your net worth can tell you many things. If the figure is negative, it means you owe more than you own. If the number is positive, you own more than you owe. For example, if your assets equal $200,000 and your liabilities are $100,000, you will have a positive net worth of $100,000 ($200,000 - $100,000 = $100,000). Conversely, if your assets equal $100,000 and your liabilities are $200,000, you will have a negative net worth of -$100,000 ($100,000 - $200,000 = -$100,000). A negative net worth does not necessarily indicate that you are financially irresponsible; it just means that - right now - you have more debt than assets.
Like the stock market, your net worth will fluctuate. However, also like the stock market, it is the overall trend that is important. Ideally, your net worth continues to grow as you age - as you pay down debt, build equity in your home, acquire more assets, and so forth. At some point, it is normal for your net worth to fall, as you begin to tap into your savings and investments for retirement income.
Since each person's financial situation and goals are unique, it is difficult to establish a generic "ideal" net worth that applies to everyone. Instead, you will have to determine your ideal net worth - where you want to be in the near-term and long-term future. If you have no idea where to start, some people find the following formula helpful in determining a "target" net worth:
Net Worth = [Your Age - 25] X [Gross Annual Income ÷ 5]
For example, a 50 year-old with a gross annual income of $75,000 might aim for a net worth of $375,000 ([50 - 25 = 25] X [$75,000 ÷ 5 = $15,000]). This does not mean that all 50 year-olds should have this same net worth. The formula can be used simply as a starting point. Your ideal net worth may be much more or much less than the amount indicated by the guideline, depending on your lifestyle and goals.
Why Your Net Worth Is Important
When you see financial trends in black and white on your net worth statements, you are forced to confront the realities of where you stand financially. Reviewing your net worth statements over time can help you determine 1) where you are, and 2) how to get where you want to be. This can give you encouragement when you are heading in the right direction (i.e. reducing debt while increasing assets) and provide a wake-up call if you are not on track.
Knowing your net worth is important because it can help you identify areas where you spend too much money. 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. To reduce unnecessary spending and debt, your needs should represent the majority of spending. (Keep in mind that you can falsely rationalize a want as a need. That $500 pair of shoes does fulfill a need - clothing - but a less expensive pair may do just fine and keep you headed in the right financial direction).
Pay Down Debt
Reviewing your assets and liabilities can help you develop a plan for paying down debt. For instance, you might be earning 1% interest in a money market account while paying off credit card debt at 12% interest. You may find that using the cash to pay off the credit card debt makes sense in the long run. When in doubt, crunch the numbers to see if it makes financial sense to pay down a certain debt, taking into consideration the impact of no longer having access to that cash (i.e. it's a good idea to keep some cash on hand for emergencies).
Save and invest
Your net worth figures can motivate you to save and invest money. If your net worth statement shows that you are on track to meet your financial goals, it can encourage you to continue what you're doing. Conversely, if your net worth indicates room for improvement (for example, over time you have dwindling assets and burgeoning liabilities), it can provide a needed spark of motivation to take a more aggressive approach to saving and investing your money.
The Bottom Line
Regardless of your financial situation, knowing your net worth can help you evaluate your current financial health and plan for your financial future. By knowing where you stand financially, you will be more mindful of your financial activities, better prepared to make sound financial decisions and more likely to achieve your short-term and long-term financial goals.
More From Investopedia