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Knowing Your Net Worth is Key to Managing Your Money

By: Investor Solutions

By: The Financial Planning Association

Grab a pen and a piece of paper and jot down off the top of your head your household net worth. Net worth, in case you are not exactly sure, is the total value of your assets minus your total liabilities.

The first thing to know about your net worth estimate is that it probably is wrong not just by a few dollars, but by a lot of dollars. Numerous studies have found that families either don’t have any idea what they are worth, or their idea is wrong. For example, a study last year by Jay Zagorsky, a research scientist at the Center for Human Resource Research at Ohio State University and Boston University School of Management, estimated that 70 percent of households underestimate their net worth, and 25 percent overestimate their wealth.

Furthermore, those who underestimate their wealth do so by nearly 40 percent. For every dollar they are really worth, they think they are worth only 62 cents, and for each dollar their wealth rises, they think they are gaining only 27 cents.

Why should you care about your net worth? Net worth is the best measurement of the state of your financial health. Most of our major spending, investing and other financial decisions are made, or should be, based on our net worth and obviously the more accurate that estimate, the better. For example, if you overestimate your net worth, you may not save as much as you should for your retirement, or you may overspend based on your perceived wealth. Underestimate your net worth, and you may either save more than necessary for your retirement, take on extra investment risk in the belief you need to make up for what you perceive as insufficient wealth, or buy insufficient insurance coverage.

The recent focus on the wealth effect illustrates how net worth affects household financial behavior. During the late 1990s and early part of 2000, American consumers spent heavily because they had seen their stock investments rise in value and that made them feel wealthier however accurate that feeling was for any particular household. However, with the decline in the stock market in 2000, the total net worth of American households fell in 2000 for the first time since the federal government began collecting figures at the end of World War II. Many economists attribute the nation’s current economic slump to declining consumer confidence in response to their declining net worth.

Calculating an accurate picture of your net worth is relatively easy. Computer programs or worksheets are readily available that run you through the process. Generally, start with how much money you have in checking and savings accounts, U.S. savings bonds (current value), and certificates of deposit and money markets. Add in the current market value of your stocks, bonds, home, real estate investments, retirement plan accounts, individual retirement accounts and business interests. Include the surrender value of your annuities and the cash (surrender) value of your life insurance. And add up the value of your personal belongings: jewelry, automobiles, clothing, furnishings, appliances, collectibles, computers, and so on. Their value should be their current market value what you could get in cash for the items.

On the liability side, include the mortgage on your home, car loans, student loans, credit-card debt, unpaid taxes, insurance premiums, charitable pledges and outstanding bills. Subtract your liabilities from your assets. That’s your net worth.

Take this measurement every year. It provides a benchmark about how well you are doing. Is your net worth positive or negative, and perhaps more important, is it improving or getting worse? Take a freshly-minted college graduate saddled with student loans. Their net worth is probably negative. They land a job that pays well. They buy a new car, loads of consumer items, maybe even a new home or condo. Current income is enough to pay the bills, but that’s about it. What about their net worth? Unless they’ve made a concerted effort to pay extra toward the student loans, they still have a negative net worth. In fact, the car and house have added to that negative picture. If they aren’t salting away much money in savings and investing, their overall financial health isn’t as sound as their regular income would make it appear.

This column is produced by the Financial Planning Association, the membership organization for the financial planning community, and is provided by a local member in good standing of the FPA.