Common Liabilities That Hurt Your Net Worth
Your net worth is the sum of everything you owe (your liabilities) subtracted from the sum of everything you own (your assets):
Net Worth = Total Assets - Total Liabilities
If your assets are greater than your liabilities, you have a positive net worth. If, on the other hand, your liabilities exceed your assets, you have a negative net worth. Your net worth is rarely static - rather, it changes frequently in response to your earning, spending and saving habits. Your net worth is a financial report card that shows how you are doing financially at that point in time. When calculated and reviewed periodically, your net worth statements can show you if you are on track to meet your short-term and long-term financial goals. By seeing the facts of your financial situation in black and white - on your net worth statement - you can identify both the successes and failures of your financial history, thereby enabling you to make better financial decisions in the future.
If you want to improve your net worth, you have three options:
1. Increase your assets (not to be confused with simply buying more "stuff"); or
2. Reduce your liabilities (pay down debt and stop spending so much - i.e. make better purchasing decisions); or
3. A combination of both asset accumulation and liability reduction.
Your liabilities are everything that you owe - in other words, your debts. Remember the old saying, "A penny saved is a penny earned?" This is very true when it comes to your net worth statement. Every penny that you keep out of the liability side of the net worth equation essentially ends up on the asset side. For instance, the money that you saved by not splurging on an unnecessary purchase might end up in your savings account (asset) - instead of on your credit card bill (liability). This article will take a look at a few common liabilities that can hurt your net worth.
Your house is probably your most valuable asset, but it is also likely your biggest liability. Your house increases your net worth only by the amount of equity you have. To calculate equity, subtract any outstanding mortgages (or liens) from the home's current market value. For example, if your home's market value (what you could realistically sell it for right now) is $200,000 and your mortgage is $150,000, your equity would equal $50,000:
$200,000 (asset) - $150,000 (liability) = $50,000 equity
Because equity is dependent upon the current market value of the home, the amount of equity that you have in your home is not a constant. Unfortunately, it is possible to have negative equity, which occurs when your mortgage exceeds the market value of the home. The amount of equity that you have can increase as you pay down debt, when property values in your area increase or if you make improvements that increase the home's value.
In general, renovations that pay off the best tend to bring your home in line with other houses in the area. If area homes have hardwood floors, granite countertops, stainless steel appliances and updated bathrooms, you will likely be able to increase your home's value with similar renovations/upgrades. Renovations that fall outside the "norm" for the neighborhood - such as an addition that makes your home twice the size of the surrounding homes - can actually decrease your home's value (people are unlikely to spend the extra money on a big house if it is surrounded by smaller homes).
Your house is a financial commitment that lasts for years. Many people, for example, make 360 mortgage payments before the house is paid off. If you can get into a less expensive house to begin with, that's a lot of change left over after 30 years (not to mention, the money saved could be working for you in investments). Doubling up on mortgage payments, or even making one extra payment a year, can save you considerable money in terms of interest, and allow you to reduce the debt faster.
Student loan debt is another common liability that can hurt your net worth. The average student loan balance as of the first quarter of 2012 was $24,301, according to the Federal Reserve Bank of New York. About 25% of borrowers owe more than $28,000; 10% owe more than $54,000; 3% owe more than $100,000; and 167,000 people (less than 1% of student loan debtors) owe more than $200,000.
While many hope to pay off their student loans quickly, the reality is that this debt can burden people for decades. Out of 37 million people in the U.S. who have student loan debt, about 40% are under age 30, close to 42% are between the ages of 30 and 50, and 17% are older than 50.
Student loan debt does not just burden the younger, fresh-out-of-college group; it remains a liability on many people's net worth statements into their retirement years. The good news is that people with college degrees tend to earn more money throughout their careers. In fact, high school graduates may earn $1.3 million throughout their working lives, while those with a bachelor's degree earn $2.27 million. With a doctoral degree, the average jumps to $3.25 million.
Credit Card Debt
Credit card debt is the third largest source of debt among U.S. households (following mortgage and student loan debt). People with credit card debt, on average, owe more than $15,000. The minimum monthly payment on credit cards is typically a percentage of the outstanding balance. On $15,000 debt, a 2% minimum payment would equal $300 each month. Here are some sobering facts about this debt. If you make only the minimum payment each month (and do not add to the balance), it will take you 33 years to pay off the balance and you will end up paying $20,110 in interest (these figures assume a 14% interest rate). If you double your payment each month and pay $600 (instead of the minimum payment of $300), you could pay off the $15,000 in only three years while paying only $2,839 in interest.
You can use online credit card repayment calculators, such as the one on the Federal Reserve's website to find out how long it will take you to pay off your credit card balance making the minimum payment, and how much interest you will end up paying.
Many people who purchase a car do so with financing, and the loan counts as a liability on your net worth statement. Many households finance multiple vehicles simultaneously - one for each adult, and perhaps one or more for children of driving age. The loans can add up to a significant percentage of your total liabilities. Because many cars can be financed with as little interest as 0.0% (for qualified borrowers), it may not make financial sense to pay down the loan just to remove it from your liabilities.
However, if you are paying a higher interest rate on the loan (for example, 4%), and you have money earning very little interest in a savings account (it's not uncommon for savings accounts to earn less than 0.5% interest), it might make sense to pay down the debt and save money in the long run. If you crunch the numbers and decide it is better to pay off the loan, it is a good idea to make sure you still have emergency funds for unexpected expenses - you may not want to pay off the car if that leaves you with nothing in the bank.
The Bottom Line
Your net worth statement can be a strong motivator to improve your financial health. Just like stepping on a scale can motivate you to eat better and get more exercise, your net worth statement can provide a wake-up call if you need to be more proactive towards your financial health. These liabilities are not the result of unnecessary purchases. After all, it is reasonable to have a home, a student loan, some credit card debt and a car. That said, the bigger the financial hole that you dig yourself into, the steeper the climb to get back out. Making better financial decisions on the front end can make it infinitely easier in the long run to meet your financial objectives.