As personal finance nerds, we are interested in where every dollar goes, what bucket it falls into and how that compares to the previous week, month, and year. Most people are generally not interested in tracking every dollar. Some people say, “I’m just not a math person” or “that’s just more detail than I care to know.”
If forced to come up with two metrics to evaluate your financial progress, we would have to say without a doubt, it’s your net income and net worth. Let’s define both and then let’s talk about why these are the most important financial measures to track.
What is your Net Income?
Your net income is simply taking your monthly after-tax income (the amount that comes into your bank account) and subtracting all of your expenses during the month (housing, food, utilities, transportation, debt payments, personal, etc).
Net Income = After Tax Income – Expenses
If you were a business, your Net Income would be called ‘profit’. You need to know what your profit is each monthly. You don’t want to run a business that’s losing money each month. You want your net income to be positive each month and you want it to be growing over time.
A common mistake people make is that as their income increases, they increase their spending along with it (a.k.a. lifestyle inflation). So if you get a 3% raise at work, but you increase your spending by 4%, you could actually be worse off financially, that’s why tracking net income (profit) monthly is so important.
What is your Financial Net Worth?
Your financial net worth is simply adding up all your financial assets (everything you own) and subtracting all of your financial debts (everything you owe).
Net Worth = Assets – Debts
Financial Assets can include real estate, securities (stocks, bonds, mutual funds), vehicles, checking, savings, cash or anything you can sell and turn into cash. Alternatively, your debts can include mortgages, credit card debt, personal loans, home equity loans, student loans, etc.
Let’s be clear about a few things, first, never confuse your financial net worth for self-worth. Regardless of whether you’re a millionaire or your net worth is negative, it says nothing about who you are as a human being. We live in a ‘more is always better’ culture, we glorify millionaires and condemn the poor, but that is not the goal of this measure. Your financial net worth is simply a number that applies to you individually or as a family to track and increase over time to assess how close you are to reaching your financial goals (i.e. financial independence).
Second, the majority of Americans have either zero or negative financial net worth, so if they sold everything they owned, they would either have nothing left over or would still owe money. Many young professionals fall into this bucket due in part to student loans. Building your savings and getting out of debt both increases your assets and reduces your debt, thereby increasing your net worth.
Why are net income and net worth the most important numbers to track?
Good question! Why not Salary? Savings? Credit Score? The answer is simple, your net worth is the bigger picture goal, net income is how quickly you’re moving towards that big picture goal. In your financial journey to your financial destination, your net worth would be the miles traveled to your destination, your net income is how fast you’re driving. There are all sorts of metrics that you could measure if you were taking a cross-country journey, but if we had to choose only two, we would want to know how far we’ve gone (net worth) and how fast we’re moving (net income).
Both Net Income and Net Worth are simple formulas and there are only two ways to increase them:
- Increase income/assets
- Reduce expenses/debt
Unfortunately, the majority of our expenses (after our essential expenses) are for items that decrease or depreciate in value. So when we buy a pair of shoes or a phone, if we were to sell it used a month later, we would receive much less in return than we paid for it. On the other hand, if used the same money to purchase stock ownership in the company that manufactured that shoe or phone, that stock could potentially increase or appreciate in value over time. When you hear phrases like ‘the rich get richer and the poor get poorer’ that is partially because wealthy people are more likely and able to purchase appreciating assets (e.g. businesses, securities) and the middle class and working class are more likely to buy depreciating liabilities (i.e. debt – a.k.a. stuff that makes us look/feel rich, but actually make us less wealthy). A depreciating liability, such as a car note, is a double loser because not only is the car rapidly declining in value, but it’s also financed from a bank, which means paying additional money in interest (increased cost & reducing value).
We have to change how we look at what we buy and whether showing off our expensive stuff is more important than actually growing our wealth. Recent studies have shown that 76% of Americans are living paycheck to paycheck, that includes high-income earners, so the people we compare ourselves to or try to impress are likely broke.
We also have to change the way we think about our income. It’s often said when talking about investing, that ‘you don’t want all your eggs in one basket’, you have to diversify your investment assets to reduce risk. Well it’s much less talked about, but just as important to diversify your income because having one source of income is just as risky as having all your investments in one stock.
In order to put more wins in the asset/income columns, the focus should be to develop multiple sources of income and free your income to purchase assets that appreciate in value. Building an emergency fund, increasing your 401k contributions, contributing to an IRA, are all ways to increase your assets in the near term.
The other end of increasing your net worth is reducing your debt. Everyone has different types and levels of debt, but the most advantageous position to be in financially is having no debt. There are entire industries that rely on people getting and staying in debt. Credit cards, auto manufacturers, mortgage lenders, banks are examples. In fact, the credit card industry calls people that pay their balance in full every month, deadbeats. They are deadbeats because the card companies aren’t making any money off them in finance charges. If you choose to use credit cards, please be a deadbeat! Unfortunately, in our culture we have become accustomed to debt as a way of life. When we start to understand how much debt impacts our ability to reach our financial goals, we begin to make different choices. Keep in mind, our debt is someone else’s asset (i.e. banks, credit cards, auto companies, mortgage lenders), just like your loss is someone else’s win. If you are a lender, the loan contract is an asset that appreciates. You lend someone $20K for a car purchase and you’re paid back $22K over 5 years.
In order to reduce losses in the debt/expenses columns, the focus should be to free your income to pay off debt more quickly and avoid additional debt. Also, reduce the purchasing of items that depreciate in value. Tracking your spending for a month, using only cash for 60 days or selling possessions are all ways to increase income or reduce expenses in order to reduce debt.
The Bottom Line
The bottom line is that we cannot wear or drive wealth. In one camp, the majority of millionaires live well below their means, drive used cars, and live in modest homes (read: The Millionaire Next Door). However, in the other camp, the majority of Americans live far above their means, live from paycheck to paycheck and finance their lifestyle with debt. There are free online financial aggregators such as mint.com that will allow you to centralize all your financial accounts and calculate your net worth automatically. Tracking your net worth monthly allows you to become more aware of not only which camp you’re in, but also allows you to know how close you are from moving from one to the other.