This article first appeared on DailyWorth.
Assessing your personal financial reality can be a bit daunting. But it’s time to lean into that fear and face your current financial landscape. It’s like dieting: When you're trying to lose weight, you can’t be afraid to step on the scale — you need that data to get started!
Begin with your net worth. Net worth applies to individuals as much as businesses — it’s a measure of the total monetary value of something. Here, that something is you. And when your net worth is increasing, you are in good financial health. Your net worth is calculated by taking what you own (your assets) and subtracting what you owe (your liabilities). Remember, although the dollar amount of your income is important, it (if managed properly) is only one small component of your net worth.
Your first step is to create a list of everything you own and its current value. Unfortunately, not all your stuff is a monetary asset. For example, stained furniture and worn-out clothing don’t count. Do include personal assets, such as your home, car, art, and jewelry, as well as financial assets, such as cash, bank accounts, brokerage/investment accounts, retirement accounts and other holdings that have a cash value (such as college savings or whole life insurance policies).
When assessing value, it is important to understand the distinction between book value and market value. Book value is the price you paid for something, and as long as you own that asset, that value never changes. In contrast, an asset’s market value is the price at which you could sell the asset today.
Ideally, the market value of your assets is substantially higher than their book value. However, the reality is that some of your personal assets — aside from real estate or collectables like art or jewelry, where an appraisal is suggested — will have depreciated in value (their book value will exceed what they are worth in the open market today).
The same valuation principle holds true for many of your investment and retirement-related financial assets. Each has a book value, aka “cost basis,” which is the price you paid for that security or debt instrument. Market value is what another investor is willing to buy that same instrument for today. For most liquid assets, the transfer of ownership occurs daily via security exchanges like the NYSE or NASDAQ, so it is easy to determine the market value. But the market value of liquid financial assets — such as partnerships, ownership interest in private companies, etc. — is much harder to determine and may require the assistance of a valuation expert.
Now that you've identified what you own, create a list of what you owe. This list should include all outstanding commitments you have. In addition to outstanding balances, be sure to include the terms of each liability (for example, the interest rate and duration of each loan) as this will come in handy when you create a strategy to pay down — and eventually pay off — your debt.
Your list of liabilities might include (but not be limited to) current balances on mortgages, auto loans, lines of credit, credit cards, student loans, personal loans and other types of promissory notes.
Now that you have your two totals, subtract the dollar amount of what you owe from the grand total of what you own, and voilà, you have your net worth. By looking at your financial landscape this way, you will quickly see that there are only two ways to increase this number: increase your assets or decrease your liabilities.
To accomplish the former, you need to increase the money in your bank accounts; experience an appreciation in the value of your home or other physical assets; or increase your retirement, investment or other financial accounts through contributions or an increase in market value. To decrease your liabilities, you need to pay down or pay off your debt.
Building your net worth doesn’t happen overnight. It is a slow and steady process that requires patience to allow your assets to grow over time, as well as a commitment to manage your income effectively and consistently contribute to your assets. But you can do this — and assessing your net worth is the perfect way to start!