A few years back, I had a little net worth bashing session.
Over time (and increased net worth) my view on this financial metric has softened a bit, but not much.
A softer side comes from an increased appreciation for tracking the full value of all of the assets you have. It is hard to know where you are at, where you want to get to, and how long it will take to get there if you do not have something to measure.
What do I still not like about net worth as a financial indicator? Before I explain, first, a quick recap of how to calculate net worth. At it’s simplest:
net worth = total assets – total liabilities
Common assets include: market value of real-estate property, bank deposits, non-retirement investments, retirement accounts, depreciating assets (vehicles, boat, basically any possession you can sell).
Common liabilities include: mortgage/home equity loan debt, student loan debt, auto loans, credit card debt, medical debt, or any other outstanding debts.
With that clarified, the thing that still bothers me about net worth comes from the context in which it is used. 99% of net worth conversations, articles, and online forum discussions are centered around retirement and early retirement. In fact, outside of applying for student financial aid, a new loan, celeb jealousy rants, or bragging in a way that makes you lose friends – I can’t think of any other times net worth is brought up.
Taking things a step further, net worth is often used as a measuring stick in retirement discussions to judge ones retirement picture. Here’s the problem with that – what value is there in net worth (outside of ego boosting) if you cannot use that net worth to generate income or live off of?
Is there value in including the equity in a $1.5M Bay Area home in net worth, when the owner occupant has no intent to leave?
Is there value in including a debt-free $100K home in net worth calculations, when no matter where the owner moved, they would probably end up paying more for the next home (or increase expenses through renting)?
Is there value in adding the full balance of 401K, IRA, stock options, or other pre-tax deferred compensation in to net worth (as most do) versus a calculated after-tax number?
And is there value for an aspiring early retiree to add in retirement investments if they want to judge their ability to retire early, when they have no plan to withdraw those investments until retirement age?
I don’t think so.
Usable Net Worth
I don’t want to dismiss the net worth metric completely, but I have created a modified version that makes it more useful for retirement and early retirement purposes. I like to call it “usable net worth”.
Maybe it works for you, maybe you’d rather stick to the standard net worth calculation – either way, let me know what you think.
usable net worth = total usable assets – total liabilities
Usable assets include:
- market value of current home minus estimated market value of next home (if no intent to move, = $0. If a negative amount, add to liabilities)
- market value of rental property
- bank deposits
- non-retirement investments
- after tax retirement accounts (Roth)
- pre-tax retirement accounts and deferred comp AFTER estimated post-tax value
- non-essential depreciating assets (if you need a car, do not add its value. If you have a boat and intend to sell it, add the expected market value at the time of sale)
Total liabilities include:
- Mortgage/home equity loan debt
- Student loan debt
- Auto loan debt
- Credit card debt
- Medical or any other outstanding debt
You’ll notice that the big differences are all on the asset side. Here’s a little more on each:
- Home: the problem with including home value in net worth is that everyone needs a roof over their head. If you have no intent of selling your current home in favor of another cheaper home and pocketing the cash to use or invest, then why add this value to your net worth? What value is there in calculating net worth if 30, 50, 70% of it is tied up in a home or will be tied up in your next home?
- Pre vs. Post Tax Balances: I see very few people factor in taxes to their pre-tax (Traditional 401K, IRA) retirement accounts and deferred compensation. You will have to pay taxes on it at some point, so why include the taxable portion in your net worth? For simplicity, I assume my current tax rate. In reality, when I start withdrawing these assets, my tax rate will probably be lower, but I’d rather be conservative and consider any additional assets a bonus.
- Depreciating Assets: as noted, unless you intend to sell your current asset, there is no point in adding its market value to your net worth.
What remains, after the modifications, are the assets that you can actually use to invest or cover your living expenses. No ego, no inflated number that has no real world use, just good old rubber-meets-the-road usability that can give you a much more accurate picture of how close you are to financial independence, or secure you are if already achieved.
And isn’t that what’s important?
I agree with you that assets that you have no intention to sell in the near future should be counted towards your net worth. The world we live in always strives for the bigger the better. My net worth using your formula is not all that impressive but at least it’s in the black, these days I don’t think most people can say that.
I actually did a calculation like that on my finances earlier this week without really realizing that’s what I was doing. It was just a pragmatic exercise necessary to determine when I’d be ready to invest in rental real estate.
Thanks for clearly outlining the theory behind a necessary practice! Hopefully the folks at mint.com and other purveyors of financial tools will start to see the benefit of knowing “Usable Net Worth” and start implementing it as a standard feature.
That’s a really good point. I was just calculating my net worth the other day and it was much higher than I expected. But, as most places indicated, I included all assets – including about $25,000 of “stuff” in my house (TVs, computers, furniture) etc. But that doesn’t really help me – including your house and car example – if I’m sitting on the street with this net worth in my pocket but no couch to sit on. You still are always going to have those expenses so your idea of usable net worth seems like a much more meaningful measure of how you are doing financially.
I’d never start tallying stuff. Unless you plan to sell it all and go live in a tent, what’s the point? TV? Couch? Wall art? not worth counting, unless it’s a Picasso.
Would it be better to measure returns vs expenses? If I have an extra car that I don’t use then its not really net worth, is it? And a 50,000$ emergency fund that’s only earning 1% (-2% after inflation) is not nearly as interesting as 50,000$ earning 7% (4% after inflation). Should the emergency fund be considered an expense? Using a ration would allow you to model the increase in net worth of downsizing a home while still differentiating between rental and ownership. (not that one is inherently better than the other)
All good points. I’m sure there are a dozen different ‘net worth’ numbers one can come up with.
For us, I don’t count the house, but do count the mortgage. So my net number is what I’d have after house is paid in full. If we downsize at some point, that’s just extra, but for now, we ignore it.
The cars? Well, if the Mrs and I die in a plane crash, the kid can sell our cars. The way my wife drives, she’s taking the car with her. Either way, not counted.
The retirement accounts are interesting. Even though they are pre-tax, I’d be hard pressed to choose a number. I have decades of carried forward real estate losses a well as stock losses from the great dot com crash that give me a $3000/yr deduction, etc, so I’ll be paying a near zero tax bill for the next decade of early retirement. Instead of adjusting one’s assets, I just adjust the ‘number’, what one needs to retire. If $50k/yr will do, adjust for taxes, if any, then multiply by 25.
I’ll throw another wrench into the equation – how do you account for social security? $40K in SS is $1M that you ‘don’t’ need to save for retirement. But it’s not quite n asset, right?
Unless you are close to being able to claim it, I would not count SS for 2 reasons:
1. Who knows what the payout (if any) will be 30-40 years from now? Or age limitations, for that matter.
2. Future projected payouts are based off of 35 years of earnings (which may or may not happen).
To put it simply – it’s money you don’t have, don’t know that you’ll get, and if you do, in an undetermined amount. Consider it a bonus, not an asset.
I’m 52 this year, and my bride, 58. So it’s not as far away as 30 years, but I am still wary of what our benefit will be. She has her 35 years in, and I’m working part time, for joy, not money, so I’m just counting my 30 years in the system.
We hit our number, but what’s interesting to me is that the projected social security benefit is over 1/3 of our current budget, so, we’re on track to have been one of those who oversaved. Had we trusted the system, we’d have lowered our number a bit to account for SS kicking in, but I’m in full agreement with you. Wont count it till it’s in my hands.
I live by the notion that most metrics are pointless in a single instance anyway other than giving a stand alone value. If, as with net worth, the value raises while using a standard calculation to estimate it, then the change is measurable and therefore useful to each individual. This is how I think it should be used as a financial indicator. Nothing stays the same. Why should a single instance be that definitive.
Great points! I agree with you on those. Why will you include the house that you’re going to live in for the rest of your life in your net worth? It’s just not right.
Net worth is a nice number to know and track but by itself it doesn’t tell much. I think the best and pretty much only use for the net worth is to make sure it’s going up. I like the idea of not really including your house in the calculations since even if you sell it, it will be transferred to the next house.
I have many more years before I retire, but I think I have accumulated prettty well for only being 32. After seeing what can happen after the housing bust and how difficult it can be to access the equity in ones home I have decided to only use “liquid assets” in my formula for calculating net worth. I will probably added the value of my rental property in once it is paid off.
Net worth is a good metric to focus on because it is a big picture, longterm view of your financial health that is comparable overtime. So, I can compare where I’m at today, compared to 10yrs ago.
I mostly agree with your logic, except on a couple points: 1) if I exclude my house from my net worth and compare to a time in my life that a I was not a homeowner, it will appear that buying a home decreased my financial health compared to renting. I’ve owned 6 different primary homes, so my net worth would be a rollercoaster with your method. Plus, it doesn’t really matter if I plan to move, buying a bigger house with a bigger mortgage has no impact on net worth (except for transaction costs). 2) I like the thinking on discounting tax-deferred retirement accounts. However, I would argue that a premium should be added to Roth assets, because the taxes have been prepaid for both the principal and future earnings. That makes a Roth worth more than any other investment account.
With real estate I might even go one step further and subtract 6% realtor fees plus whatever other costs it would take to sell. The market value isn’t what you what you put in your pocket at the end of the transaction.