What’s the Best Measure of Financial Success?

The following is a guest post from Aaron of Personal Finance for Beginners.

If you’ve just started to focus on your personal finances, it can be difficult to know where to start. There are many important areas of money management – debt, budgeting, saving, investing – that make it hard to decide where to prioritize your attention and how you should measure your progress.

In this post, we’ll take a look at pros and cons behind four of the most popular numbers used to evaluate your financial success:

• Credit score
• Income
• Savings rate
• Net worth

Improving any one of these metrics has the potential to improve your financial wellness – but is there one number that rules them all?

Credit score

Your credit score is a number that lenders use to measure how responsible you are with managing debt. A credit score is calculated from five major factors. The two most important factors are making your payments on time each month (payment history) and how much you owe in relation to your total available lines of credit (credit utilization).

Pros: What are the benefits of having the highest credit score possible? Having a high credit score qualifies you for the lowest interest rates available on your mortgage, auto loan, student loans, etc. You don’t need a perfect credit score, but having an “excellent score” (750+) can save you thousands of dollars in accrued interest over your lifetime.

Cons: While having a good credit score is important when you’re buying a house or applying for any other loan, its impact is fairly small in the big picture of your personal finances. A bad credit score will likely hold you back from achieving some of your financial goals far more than a good credit score will be able to help you. 

Having good credit opens the door to new financial opportunities and flexibility, but nobody is becoming wealthy or retiring from a perfect credit score alone – it’s just a tool.

Income

What individuals do you see in your mind when asked to think of people who are “rich?” When talking about the affluent in our society and culture, we aren’t always talking about those with a massive net worth – we often imagine the “big earners” like actors, musicians, or tech giant executives.

Because most of us depend on a salary for our income, getting a raise or promotion is the most common way to increase this the number. It’s not the only the way to increase your income, however. You can also take on a second job, find a side hustle that suits your interests, or start your own business.

Pros: Increasing your income allows you to reach your financial goals more quickly. A high income can give you the option to enjoy a higher quality of living, covering your “needs,” “wants,” and even a few luxuries depending on just how much you earn. You can pay down any debt, max out your investment accounts, and have cash available on hand should a good financial opportunity present itself. 

Cons: Increasing your income doesn’t guarantee financial success. Just take a look at the celebrities, professional athletes, and lottery winners who receive seven-figure paychecks – many find themselves broke and filing for bankruptcy just a few years later.

How do you adjust your finances after you get a raise? Any dollar without a purpose is likely to go to waste. Without a budget and long-term financial plan, you can find yourself struggling without financial uncertainty regardless of your income level.

Savings rate

Savings rate is likely to be the least commonly discussed financial metric of the four mentioned in this post. Your savings rate is the percentage of your take-home income that you’re contributing toward retirement.

While your savings rate may not receive the same attention as your income or net worth, it’s a popular measuring stick especially among those who are pursuing an early retirement.

Pros: For most people, the end goal of personal finance is reaching financial independence. After you reach financial independence, you may want to continue developing your career, find a different job or volunteer work that better fits your values, or transition into “play lots of golf” or “go travel the world” retirement. Regardless of your end goal, your savings rate is the best direct predictor of how long it’ll take you to pass the finish line.

Cons: Maintaining a high savings rate often depends on keeping your spending low. Even if you’re able to establish a high savings rate early in your career, it’s hard to forecast how a major life decision, such as marriage, children, or relocating to a city with a higher cost of living might cause your living expenses to skyrocket your spending and completely shift your measure of success.

Net worth

Your net worth is the sum of all of your assets minus all your liabilities. This number provides a snapshot of your financial situation at any specific point in time (as it fluctuates in real-time with any personal transactions or changes in the market). If you’ve ever wanted to be a millionaire, it’s your net worth that needs to reach a million dollars!

Pros: Your net worth offers a balanced understanding of your financial situation by considering both the positives (assets) and negatives (liabilities). Unlike the other metrics we’ve discussed, your net worth is by far the most comprehensive. Calculating your net worth requires reviewing all of your financial information in one place, which is becoming easier than ever with tools like Mint or Personal Capital.

Cons: A high net worth, just like a high income, only holds value if you know how to make it work for you. To really optimize your finances, you still need to drill down deeper to identify areas of improvement. If you have significant amounts of student loan or consumer debt, you may have a negative net worth that takes years to reach the positive. Sometimes it’s easier to focus on other financial metrics that can be improved more quickly.

Conclusion

There’s a brief overview of four major measures of financial success. Each number can have a major impact on your finances in its own right, and your interest in each metric will likely shift as your progress through your financial journey.

Here’s how I’d rank these four metrics by importance:

1. Net worth
2. Savings rate
3. Income
4. Credit score

When all is said and done, your net worth dictates when you reach financial independence. It also indicates success in the other metrics: you’ve been able to hold on to the income you’ve earned by saving money, investing toward retirement, and acquiring assets.

Do you agree that net worth is the most important measure of financial success? Why or why not?

Comments

[freebird]

If I had to pick a single number to serve as a progress marker towards financial independence, I'd combine three of your four numbers as follows: net worth divided by ( income multiplied by ( one minus savings rate ) ). IOW don't measure wealth in dollars, instead measure it in years.

This formula may seem crazy complicated but I believe it is the best metric. The denominator of annual income multplied by (one minus savings rate) is your annual spending rate. Dividing your net worth by your annual spending rate tells you how many years of expenses your net worth can support. You want this ratio to grow as quickly as you can. Once it reaches 33 years your net worth can support a safe withdrawal rate of 3% per year, and you are financially independent. You can afford to retire at that point.

One takeaway from this formula is that for reaching financial independence income is not as important as savings rate. Why? Because while net worth will grow over time proportionally to income, the denominator is also proportional to income, so the income factor effectively cancels out. But a higher savings rate will increase the numerator and also decrease the denominator, so you get a double whammy effect on this ratio.

This is why a higher income won't automatically get you closer to your nest egg target-- only if your savings rate increases as your income grows. As they say even if your income grows, spending everything you make doesn't bring you any closer to retirement.

[texashaze]

Credit score is meaningless. You can have bad credit and be a millionaire. It's about 2 things, net worth and cash flow. Net worth is a long term metric and cash flow short term. Both of these have different meaning based on your stage in life. I've had points in my life where my net worth was great but cash flow low. There have also been points where net worth was low but cash flow high. Looking back net worth high/cash flow low was a tough time but I felt better knowing the long term.

It would be interesting to take this post to the next level and evaluate those factors at various stages in one's life. For example, when you're young Credit Score and Cash Flow are important. When you're in your at my stage (squeeze phase - taking care of parents and kids in college) cash flow is critical.

[Kevin S]

Actually, a full and effective guide to measure. I've read thoroughly and I believe it would be great if you add "Emergency fund" as another measurement tool. Anyway, it's one of the best post I've seen online. Thanks.