How To Improve Net Worth By Decreasing Liabilities
It is a requirement for public companies (and a good idea for private companies) to compile and produce reports based on their financial positions. It is likely you have heard of at least one of these types of reporting: balance sheets, income statements or cash flow statements. Each provides a different picture of a firm's financial well-being. In a similar manner, people can create for themselves comparable outlines of their own fiscal positions. This is done by calculating one's "net worth," which is a simple equation consisting of adding up one's assets and subtracting off his or her liabilities. This immediately begs the question of how one might go about improving the outcome of the equation and improving one's net worth. First, some brief terminology review. An asset is essentially anything you own which has some cash value: your bank account, your car and the spare change in your wallet all count toward your tabulation of "assets." It is essential to think of your assets in real cash terms or "market value." Do not estimate value based on what you paid or on intangible elements like sentiment. Only consider the "liquidation value."
Calculating Net Worth
In other words, if you were to sell this particular asset today, what would be the price received? This can be tricky as many people overestimate the value of certain objects or ascribe value where none is warranted. An item is only as valuable as the amount of money someone is willing to pay for it. It is also appropriate to include your salary and any income derived from investments. Liabilities, for our purposes, are basically what you owe. The balance of your mortgage, credit card debt, student loans, or even things like rent and utility bills are all examples of liabilities. While assets can be thought of as cash "inflows," liabilities can be considered cash "outflows."
Increasing Net Worth
These are a bit easier to evaluate as often a third party is dictating the nature of your liabilities. If net worth is the calculation of our assets minus our liabilities, then it should be obvious that to increase net worth, one must increase asset holdings or decrease outstanding liabilities. The problem is that for many increases in assets there is a commensurate increase in liabilities (eg. buying a house usually requires a mortgage). Additionally, people only make so much money at their jobs, and negotiating a raise may be difficult. This creates a necessary limit on asset creation as spending beyond your ability to pay will accrue debt. This does not mean that someone should never buy a house or only buy a house with cash reserves, instead it is meant to illustrate the interconnected nature of assets and liabilities. Ideally, one should pursue a strategy that allows for the beneficial movement of both assets and liabilities simultaneously. A good example of this would be investing in a 401(k).
Making Small Changes
This defers your tax-liability and increases your asset holdings. The difficulty faced by most people is that they do not have the residual income necessary to adequately increase their assets beyond their liabilities. Therefore, the most appropriate measure to undertake in order to increase net worth is to examine your spending habits or your cash outflows. Finding a new, better paying job, is not as easy as deciding to forgo dining out one day a week. Note how you are spending money (your liabilities) and identify ways of reducing that burden. By reducing the amount needed to service debt, you increase the amount of money available to go into asset creation. Remember, decreasing liabilities is not simply about decreasing your debt payments; it is about managing your overall spending. Decide not to buy the latest smartphone or turn off lights when you are not in a room. Small changes in behaviour can go a long way toward reducing your expenses. The bonus is that by trimming back on what you can and growing your assets, you can create more value that can be borrowed against in the future thus allowing you to increase your assets at the expense of your liabilities.
The Bottom Line
Taking the time to look into your household's net worth can tell you many things and it really is a balancing act. Incurring a liability is not necessarily a bad thing if it means getting a new car when the old one breaks down or an education to improve job prospects. The important thing is that we adequately and appropriately budget for these items and ensure that they add value over the long term. A new car to replace a dangerous clunker is a "good" purchase whereas buying a new convertible due to a mid-life crisis is less so. Assets and liabilities play off of one another, improving your position in one allows you to make gains in the other. How you do this really comes down to your own personal spending habits and how quickly you want to be able to enact change to improve your financial health.