It's Time For Your Annual Checkup

Once a year, as part of your financial planning process, you should create a statement of net worth. This statement will show you where you are at in your quest for financial security. Basically, you calculate your net worth by adding up all of your assets at their current value, adding up all of your liabilities, and then subtracting your liabilities from your assets. The result is your net worth.

In calculating your total assets, I recommend a slightly different approach. I recommend that you do not include the current value of your house in the calculation. This is a radical departure from what almost all financial planners will tell you, but I have my reasons. Let me explain. Lets say you own a house that is currently worth $300,000 and your remaining balance on the mortgage is $200,000. Traditionally, most financial planners will tell you that your house contributes $100,000 to your net worth and in fact it does, if you sell your house today at it’s current value.

But when looking at creating wealth, this money is not real, it’s paper assets, and it is not readily available. You see, if you sell your house and make a profit, you have to find another place to live. Chances are, most of that money will be needed for your next house. If you don’t buy a comparably priced house within two years, you will have to pay capital gains taxes unless your are over 55 and are using your “once-in-a-lifetime” exemption.

Since we all need a place to live, this money is really not available for investment purposes. The other issue is, that $100,000 of equity can disappear overnight if you find yourself in a bind and need to sell your house in a hurry. The market may be soft and you may have to accept a much lower price in order to pay off your mortgage and there goes your net worth.

Instead, I think it is better to focus on other assets; savings accounts, investment accounts, IRA’s, rental property, certificates of deposit, and other assets that are not required for every day life. Now, when it comes to totaling your liabilities, you have to list them all, even your mortgage. It may seem unfair, but if you stop making your house payments, you will soon find yourself living under a bridge. When you do the math using this method, you may be disappointed in the final number. In fact, the final number may be negative. I would guess that in light of the fact that most Americans have tapped out the equity of their homes and our savings rate in this country is at the lowest level in years, maybe ever, most net worth numbers are negative.

Tomorrow we will look at what makes up our liabilities. Is there such a thing as a good liability or are all liabilities bad? Also a warning about the coming effects of the new bankruptcy law.