The Importance of Net Worth

Most folks don't bother to calculate their Net Worth or do so on a regular basis.  Keeping your Net Worth in mind is critical in evaluating your finances.

Law School is an interesting experience.  And the revelations one receives there are not in the great legal concepts or big ideas, but in very small concepts that have a powerful impact in daily life.

For example, in Trusts and Estates, our professor would begin each example with "Decedent leaves an estate of 1.5 million dollars..."  The Decedent in these examples always seemed to have a lot of dough, I guess because not many people bother to litigate the Estate of a poor person.

But it got me to thinking, what was my "Estate" worth?  What was my net worth?  I had a car, but I owed the bank about as much on the loan as it was worth.  I had some furniture that was handed down from relatives.  I had the clothes on my back, and $100 in my savings account.  I had the small beginnings of a 401(k) plan.  And I had a mound of student loan debt.

I was shocked to discover that, like many young people, my net worth was negative.  And yet, I didn't feel "broke" as I had a regular paycheck.  And worse yet, I was contemplating, constantly, my next big consumer purchase.  I was treading water awfully fast, but making no real progress - just apparent progress in the accumulation of depreciation possessions.

Since then, I have made it a business to calculate my net worth on a monthly, quarterly, or yearly basis.  And I have all my records going back to that date of revelation, over 20 years ago.  And I am pleased to say, monitoring my net worth has resulted in a marked increase in it.

You see, to the average salary slave, a purchase is something you do if you can "afford the payments" or "put it on your credit card".  Most Joe Paychecks don't think about whether buying or leasing a fancy car is negatively affecting their net worth.  They can afford the monthly payments, so they think they can "afford" it.

But at the end of the lease, they may be chagrined to discover that their net worth has actually declined over the period of the lease, as they have spent tens of thousands of dollars on a car, but have nothing to show for it.

And most people do just that - spend and spend and assume that since they are balancing their checkbook every month, they are being fiscally responsible.  They don't think about the more important things - like their overall wealth.

The secret to wealth is no secret - spend a penny less than you earn.  If you do this, wealth accumulates and does not dissipate.  And of course, if you can spend a dollar less than you earn, then wealth will accumulate even faster.

I recently went to visit someone in a neighborhood of very nice $150,000 homes.  They were well-made homes, but due to the recession, were selling very inexpensively.  I was shocked to see that many of the homes had new Mercedes and BMWs parked in the driveway.  I was shocked for two reasons.  First, most of these homes had two- or three-car garages, so there was no excuse to park $50,000 cars out in the rain and sun.

But secondly, and more importantly, I was shocked to see that people in this inexpensive development were buying cars that cost 1/3 or more of the cost of their homes.  If asked, most would say they are living "paycheck to paycheck" and complain about debt.  But at the same time, they were spending as much money in 3-4 years on car payments as would pay off more than 1/3 the balance on their mortgages!  Two or three fancy cars easily equal the price of the home!

But then I thought back to my youth, when I was 21, and "had to have" a new car, because I had a "good paying job" and "I could afford the payments".  I had a perfectly serviceable and working car that could have easily gone another fiver years without repair, but I chose instead to buy a car that cost about 1/3 the price of the home I was living in at the time.  Between the cost of the car - and the staggering cost of collision insurance for a young person - I could have paid off the mortgage on that house in five years or so.

And that money, compounded over 30 years, well, it would be worth hundreds of thousands of dollars at retirement.

But, like most salary slaves, I thought in terms of monthly payment only and not what the cost to my net worth was.  So I bought and consumed up to the limit of my income - and beyond.

If you take away nothing else from this blog, remember the concept of net worth and analyzing every transaction in your life in terms of how it affects your net worth.

If you want to become wealthy, you have to think of money as something you own and not something that just slips through your fingers every month in a flurry of bills.

Once you think of things in terms of net worth, the idea of spending $400 on a new "smart phone" and another $100 a month to use it seems, well, sort of stupid, as do most consumer purchases.  You will start to think long and hard about squandering money on shiny trinkets and beads - which may not last long in this world - at the expense of your overall Estate.

Get out of the cash-flow mindset and into a net worth mindset.  It is the key to real, not apparent, wealth!