Now that we’ve covered the basics of net worth, we’re ready to really get to some meat! I may ramble a bit here, but I’ll try to stay on message. Stick with me even if I do sway a bit – I think it will be worth it. (you math majors may love this a bit too much.)
As stated in the last post, the net worth equation is as follows:
Assets – Liabilities = Net Worth
From this, a reasonable question is “where do assets come from?” Good question. I’m glad you asked.
Assets are what’s left over after you make your income (from a job, business, rental property, investments, etc.) and pay off expenses (housing repairs, food, clothing, insurance, and on and on.). BTW, why does it always seem like the expenses list can go on forever, but the income list only has a handful of possibilities? The cards are stacked against us from the start! But never fear – we will overcome the stacking!!!!
Now, back to reality.
This is how net worth is accumulated after each pay period:
• Income comes in (hence the name “in come”)
• Expenses are paid with income
• Liabilities (car payment, house payment) are paid down with income
• Whatever is left over is added to assets
• Total remaining liabilities are subtracted from this to give you a new net worth
Assets are cumulative in nature. For instance, if you have $10,000 in assets on January 1, and during the year you have income of $50,000 and expenses of $45,000, you have a net increase in assets of $5,000 ($50,000-$45,000) for the year. Add this to your starting net worth, and your new net worth is $15,000 ($10,000 + $5,000).
Because of this relationship, we have a new addition to our equation. Our restated net worth equation is:
(Income this year – Expenses this year – Payments on liabilities this year) + (Assets or the value of what I started with)) – Remaining Liabilities = New Net Worth
I hope I’m making sense to someone out there – because now I’m confused!?!?!?!
But let me simplify (for my own sake). There are really only a handful of ways to increase your net worth. They are:
• Make sure your income covers your expenses and current liability obligations with plenty left over
• Your current assets maintain their value (or even grow in value)
• You don’t keep borrowing more and more money
These can be further simplified into general principles that we’ll cover (over and over) in this blog. If you do these five simple things, you will see a radical increase in your net worth in a short amount of time. The five principles to an increasing net worth are:
1. Maximize income from all sources
2. Minimize expenses
3. Control liabilities – eliminate liabilities and limit or eliminate borrowing of any kind
4. Invest in appreciating (or at least neutral) assets only
5. Protect the value of your assets
I know, I know. Pretty simple stuff. I told you in the first post that personal finances were actually pretty easy when it all boiled down to it. It’s the “experts” that want to make them hard.
Anyway, that’s enough for today. All this math talk has tired me out. Whew!
Click here to read about Principle 1.
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