Without exception, everyone experiences a small fraction of satisfaction when they realize their net worth is higher than their contemporaries. This gives individuals a sense of happiness and triumph especially when they exceed their current financial goals. But does a high net worth really mean financial strength or stability? And is it a good indicator of future financial progress?
The truth is, while numbers are important, it does not reveal the whole truth. It is also critical to look into the quality of assets you have, its liquidity, and its ability to produce income. For example, consider someone whose net worth is valued at $900,000. He lives in a home with a current market value of $750,000 and his car is valued at $50,000. Is he in a better position than a person who has $400,000 in liquidity but whose total net worth is $800,000 assuming that the growth rates of their liquid assets are similar?
A useful way to determine your real personal wealth will be to exclude assets that are intended for your personal convenience and assets that are intended to produce money. For most, this approach will mean the exclusion of their homes, cars, jewelry, and designer clothes in the asset column. It goes directly to the liabilities column. If your “net worth” is still positive after doing this approach, then you are definitely in good financial standing.
Below are essential factors you need to consider when determining your personal wealth:
As its name implies, income is any “incoming” money you receive. It can be generated from various sources including salary, investments, gifts, interest rates, and business among others. There are many ways by which an individual can earn money but in this section, we will focus on the “earned” income.
The earned income is the money you make by committing a large portion of your day to a certain work. It represents the total value of your efforts. Unlike income from investments or real estate, you must work continuously in the foreseeable future to maintain the current level of this income.
The formula for “earned income” is very basic. The earned income is the sum of all earned income is directly equal to the total amount. Although the formula for this is simple, the actual income you derive from outside sources can be complicated. For example, some individuals might work as a waiter to earn an extra $8,000 annually. Meanwhile, some individuals might be earning more than $100,000 annually but if lay-off threatens in the near future, then their expected earned income is zero until their next job.
Because individuals spend a lot of time earning their salary, it has a great impact on how they perceive their personal wealth. If you compare it to the amount you have in liquid savings, your salary will tell you how important your ability is for your future livelihood. And if you compare it to the salary of others within your line of work, your salary will tell you if you are receiving commensurate compensation for your work.
Personal Savings Rate
The personal savings rate is usually confused with the savings account interest rate. If you want to know your real personal worth, it is important to separate these figures. The interest rate will be tackled later in the Rate of Return (ROR) section.
Personal savings rate is the measure of the amount of money you saved from your earned and passive income. It is possible to have a negative savings rate because of debts, loans, and credit. People are spending the money they have allocated as savings. Sometimes they even spend money never earned.
This figure is relatively easy to calculate. It is first important to determine the (1) earned income and (2) the annual savings amount. Use the previous year’s figures if you prefer. Your annual savings includes your retirement fund or any amount of income you don’t spend. It is also important to take “negative savings” such as credit card debt into consideration. Subtract this item in order to come up with your annual savings account.
Once you have determined your earned income and savings amount, you can use this formula:
Savings / income = personal savings rate
So if you earned $100,000 the previous year and you saved $5,000 from it, your personal savings rate is:
Personal savings rate = $5,000/$100,000 = 0.05 or 5% (positive savings rate)
On the other hand, if you made $100,000 the previous year but saved nothing, your personal savings rate is zero. And if you accumulated some debts, your personal savings rate is negative. For example, if you made $100,000, saved nothing, and have $2,000 in debt, then:
Personal savings rate = -$2,000/$100,000 = -$.0.02 or -2%
Of course, it is always better to have a savings rate above zero. In today’s consumerist lifestyle, this seldom occurs. However, even if you have a positive savings rate, ask yourself how far above you are above zero. A lot of experts recommend saving 10% of your income each year until retirement. Practically speaking though, the percentage you need to save depends on various factors including your age, expected lifespan, lifestyle, and current savings. It can be higher or lower than 10%. In essence, the recommended savings rate should be as high as you can possibly make it.
Rate of Return (ROR)
The rate of return includes the amount of money you receive from your savings account, stocks, certificate of deposit (CD), real estate, and retirement fund. In order to have a ROR, you obviously should have money in savings or in investments. This is basically a good metric of how much money your savings and investments are making. Like the annual savings rate, the ROR can be positive, zero, or negative.
Investing your money on fixed-return investments are guaranteed to give positive ROR while investing your money on stocks, real estate, and even mutual funds can result to negative ROR if you don’t choose your portfolio well. If you have multiple accounts, it is important to compute the ROR of each one but it is also possible to combine them to get an overall ROR. The ROR is, by far, one of the best indicators of your savings and investment status. By simply glancing at the ROR, you can gauge the health of your finances.
Beyond the Numbers
Numbers do not reveal the complete picture on “wealth”. Family relationships, self-reliance, age, and your financial education are factors that play a role in determining your net worth and personal wealth. Don’t disregard these things because it will not only influence your financial health, it has an impact on your overall well-being as well.
Meanwhile, self-reliance is another consideration you need to look into. Are you relying on a single person for your entire livelihood? If you are, it might be a good idea to diversity your income sources as a security measure. Your age also plays a factor because $100,000 in a bank can offer a lot more to a 25-year old executive than it does to a person nearing retirement age.
Your locale and standard of living is another important consideration. A dollar in Tennessee will give you a lot more than a dollar in Beverly Hills. Aside from your standard of living, the taxes, laws, and rate of real estate appreciation also plays a part in determining your net worth. And of course, you should never underestimate the value of health. No matter how rich you are financially, good health can never be bought. So look at the figures and beyond to know whether you’re really rich or not.