A person’s wealth is often defined by the value of his assets — but assets only tell half of a person’s financial story. A better way to measure a person’s wealth is to find their net worth via the net worth formula.
Simply put, the net worth formula is assets (items of ownership that can be converted into cash) minus liabilities (what a person owes in debts). Net worth gives a better picture of a person’s overall finances because it shows what he would have left over if he was forced to sell all of his assets to pay all of his liabilities.
Here are just a few instances when knowing your net worth can be beneficial to you.
When Applying for a Loan
Knowing your net worth can help you ensure you get the best interest rate on a loan.
Lenders want to loan money to individuals who are likely to pay back the loan in full and on time. If you owe significantly more than you own, lenders will be reluctant to loan you money. This is because lenders will see you as a higher risk of defaulting on your payments.
A bank might still loan money to a person with a low net worth, but the loan will likely have a much higher interest rate — perhaps 20 percent for a car loan — or be for a shorter period of time.
When Purchasing Umbrella Insurance
Umbrella insurance provides additional liability coverage above the limits of homeowner, auto or other insurance policies. When you know your net worth, you are more likely to purchase the appropriate umbrella insurance policy.
“Home equity is something that someone can come after in a lawsuit,” said Michael Finke, dean and chief academic officer at The American College of Financial Services. “It’s good to know to know how much you need to protect yourself from lawsuits through umbrella insurance.”
When You Want to Track Your Financial Progress
“[Net worth is] a benchmark of your wealth,” said William Dolan, senior vice president and California wealth management team leader at First Bank. That makes net worth an excellent tool to track accumulation of wealth.
Most people become wealthy gradually. In fact, about 83 percent of wealthy individuals say their largest investment gains are from smaller wins over time, rather than big risks, according to the 2016 U.S. Trust Insights on Wealth and Worth.
The median net worth of U.S. households in 2013 was $80,039, according to the Census report Improvements to Measuring Net Worth of Households: 2013 (released in March 2017). But there are more than 2 million households with $3 million or more — including nearly 1 million with between $3 and $5 million — according the 2016 U.S. Trust Insights on Wealth and Worth.
By carefully tracking your net worth — which takes debt as well as assets into account — you can better comprehend your financial progression.
Increase Your Wealth: How to Grow Your Net Worth to $1 Million
When You Want to Take Advantage of a Great Deal
If you know your net worth is high, then you will have more opportunities to take advantage of great deals, such as when the stock market fell in 2008. (It has since nearly tripled in value.)
Nearly six in 10 wealthy individuals have more than 10 percent of their portfolios in cash, according to the study 2016 U.S. Trust Insights on Wealth and Worth. “On first impression, significant cash holdings might be interpreted as a sign of concern about the markets,” the study reads. “However, the top reason respondents offered for holding cash in their portfolio was to enable fast action on an investment opportunity, such as buying in a down market or taking advantage of a rising trend.”
When Drafting a Prenuptial Agreement
When you have a clear picture of your net worth, you know what your physical assets are. You also know their value. This can be incredibly helpful when drafting a prenuptial agreement.
“It’s important to be aware of what your net worth looks like when considering a prenuptial agreement, [particularly] for a second or third marriage,” said Finke. If the marriage sours, your prenuptial agreement will clearly state the assets you had prior to the marriage, making it incredibly difficult for your soon-to-be ex-spouse to go after those items.
When You Experience Financial Hardship
Knowing your net worth can help you deal with market fluctuations, particularly in retirement.
When you retire, you rely on your savings, pensions, 401k, Social Security and other assets. Knowing your total assets will help you determine how much money you can safely withdraw. For example, say you are taking 5 percent out of your 401k annually during retirement. If you have $1 million saved, that’s $50,000. If the funds in your 401k crash to 50 percent, your 401k is suddenly worth just $500,000. If you stick to withdrawing $50,000 yearly, you will deplete your account in just 10 years.
“Down years are brutal for anyone who is taking money from a retirement fund,” said David Clausen, a wealth management advisor for Northwestern Mutual. “The key of having that balance sheet is being able to avoid having to sell when the market is down.”
Retire Early: Why Financial Independence Is the Key to Retiring Early
When You Need to Sell Assets Fast
When you know your net worth, you have a much clearer picture of which assets are liquid and which are illiquid, which is incredibly beneficial if you need to sell assets quickly in case of emergency, Dolan said.
Illiquid money might be hard to obtain quickly because it is invested in real estate or a business. But liquid assets like cash, retirement funds, trusts or antiques can be easily accessed in a pinch (for the most part).
According to the report Improvements to Measuring Net Worth of Households: 2013, home equity usually accounts for about 32 percent of net worth, followed by retirement accounts (16.3 percent), IRA and Keogh accounts (10.5 percent) and stocks and mutual fun shares (9.6 percent).
When You Want Thoughtful Professional Financial Advice
A high net worth will help you get better financial advice, said Finke.
Financial advisors can provide savvy advice on not just where to invest, but also ways to minimize taxes, timing of rollovers and trusts and wills. For example, a smart advisor should be able to tell you if your state charges higher taxes on inheritances than the federal government.
However, the best advisors don’t give advice to anyone who walks through the door. They might require clients have a net worth anywhere from $250,000 to $1 million. Then, these advisors will charge about 1 percent of the value of the funds to provide advice that might save significant amounts of money in the long run.
Read More on This Topic: Here’s What Your Net Worth Should Be at Every Age