By Toby Mathis
How much are you worth?
Maybe not as much as you think.
The way we calculate a person’s net worth is fairly simple, but it’s also outdated and fails to give an accurate picture of where the person stands financially.
Traditionally, if someone wanted to know your net worth, you would add up your assets – or at least things you think of as assets. That could be a lengthy list that, in part, might include your home, your stocks, your 401(k) account, your car, your furniture, and even your cherished Mickey Mantle baseball card.
Next, you would tally your liabilities, which is less fun but just as important. Liabilities could include your mortgage, an auto loan, credit card balances, a student loan, and medical bills.
Let’s say your assets added up to $500,000 while your liabilities came to $200,000. That gives you a $300,000 net worth, right?
The math says yes, but I argue no. Let me explain why.
Imagine you own a $400,000 house and still owe $100,000 on the mortgage. This would seem to indicate the house is a $300,000 asset, but if you lost your job tomorrow, would a bank give you a loan based on that equity? Not likely because you are unemployed. In reality, the house is a “pretend asset.” It’s worth a lot on paper – but it’s paper that’s doing you no good as you struggle to come up with an income.
What’s more, even though you are out of work, you still must pay the mortgage, the homeowners insurance, and the property tax. Suddenly, you discover that this house you considered your biggest asset is in truth a major liability.
What should count as an asset? Think of it this way: An asset puts money in your account, it doesn’t take money out. Rental property could be an asset, for example, if once you pay any expenses you still clear a profit each month. You could take that money to a supermarket and exchange it for groceries. The same goes for money tucked away in a brokerage money market account. That’s an asset. Assets feed you. Liabilities starve you. They take money out of your pocket.
Like houses, cars are “pretend assets.” While you may need transportation for your job, the car itself costs you money in gas, maintenance and repairs, making it a liability. If you used a loan to buy that car, that loan also is a liability, which means you bought a liability with a liability.
This is why we have this whole net-worth thing wrong. We create a phantom net worth in our heads that does us no good in the real world.
So, how do we create a net worth that actually feeds us? Here are a few tips, though be warned. They require patience and discipline:
- Use income to buy assets. Set aside a percentage of your paycheck to buy assets. I previously mentioned rental property as a potential asset, but you might need to start smaller. For example, you could buy a dividend-producing stock. Now that stock is providing you with additional income that you can use to buy even more assets, creating an asset snowball effect.
- Use assets to pay expenses. Depending on what assets you buy with your income, you might have rents, royalties, interest, dividends, and short-term capital gains coming in. Use some of these assets to cover your needs and your wants. This is the point where you should take a hard look at those wants because you also need to continue building your assets. If you’re not careful, you could splurge on an unnecessary expense and later regret that you didn’t use the money to buy another asset instead.
- Use assets to pay for liabilities. As I mentioned, a car is a liability. An expensive car is an even greater liability. I won’t tell you not to buy one, but if you do, you should have income-producing assets to pay for it. The same goes for a house. Let your assets pay for your mortgage. If you’re not in a position to do that yet, postpone these purchases and accumulate more assets first.
People often end up underwater financially because they fool themselves about what an asset is, and they overvalue the property they own. So, with a fresh and critical eye, take another look at your net worth – and then start working on improving it.
About Toby Mathis
Toby Mathis is the ForbesBooks author of Infinity Investing: How the Rich Get Richer And How You Can Do The Same. He also is a founding partner of Anderson Law Group and current manager of Anderson’s Las Vegas office. He has helped Anderson grow its practice from one of business and estate planning to thriving tax practice and national registered agent service with more than 25,000 clients. In his work as an attorney, Mathis has focused exclusively in areas of small business, taxation, and trusts. Mathis has authored more than 100 articles on small business topics and has written several books on good business practices, including Tax-Wise Business Ownership and 12 Steps to Running a Successful Business.
