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Your net worth is a very important number. This is the number representing the value of what you own. We have already seen how to calculate your net worth. This is especially important if you want to become financially independent. For this, you will need to accumulate a large net worth that is able to cover your expenses.
However, something we have not discussed in details is the difference between the different parts of your net worth. In this post, we are going to discuss that exactly. You are going to see that not every part of your net worth is equal. Some parts of your net worth should be treated differently.
If you want to become financially independent, you cannot consider all the parts of your net worth as equal. Some parts of your net worth will not help reach Financial Independence (FI)! And some assets will not evolve in the same way over the years. If you are serious about reaching FI, it is very important to know what your net worth is composed of.
To improve, you can use two different net worths. Your regular net worth as you know it and your FI net worth that will help you towards Financial Independence. So let’s see where all the different assets fit in the grand scheme of net worths!
Your net worth
Let’s start once again with what is your net worth. It is the sum of your assets minus your liabilities. Your assets are what you own. Your liabilities are what you owe to other people. So, in other words, your net worth is what you would get if you were to sell all your assets and pay out all your debts.
Your net worth is highly tied to Financial Independence. One of the main ways to reach FI is to have enough net worth invested to cover expenses every year. Once your net worth is bigger than your yearly expenses multiplied by 25 (for a withdrawal rate of 4%), you are financially independent. This amount of money to reach to become financially free is called the FI number. The FI number is different for everybody.
There is something important about your yearly expenses. You can remove from these expenses the amount of income you will still have in retirement. If you receive a pension of 1000 USD per month for life, you can remove 12’000 from your yearly expenses. And only then you can multiply by 25, based on the withdrawal rate you have chosen. Because you do not need to cover these expenses with your investments!
In this post, we are mostly interested in the assets part of the net worth. If you want to reach Financial Independence (FI), you will want to reduce all your debts anyway. But in view of FI, all the assets are not equal. Some assets will not help you as much as others to sustain your expenses once you are financially independent.
Therefore, we need to introduce something new: The FI net worth. Your net worth is all your assets minus your liabilities. Your FI net worth is all your assets that help to reach FI minus your liabilities. You will see that some of your assets are highly tied to your FI number.
Some people go a step further and do not include some of the assets in the net worth. But I believe that the net worth calculation should be complete. However, if you are interested in reaching FI, you should make a distinct calculation of your FI net worth.
Cash is an easy asset to understand. I am not talking only about cash in your wallet but also about cash in your bank account. This could be in a checking or in a savings accounts.
Your cash is directly available so you should count it towards your FI net worth. Nevertheless, you should be aware that your cash will lose value over time due to inflation. The amount of money will not decrease but what you can buy with it will decrease. This is important to know because if you want to reach FI with only cash, you are going to need to save a large amount of money.
As a side note, inflation is not only related to cash! Your FI number will increase with inflation. That is why you should not have all your net worth in cash.
Even though cash is not the best asset you may possess, it is definitely part of your net worth and FI net worth. It will easily be usable once you retire. And there is almost no downside in using your cash to cover your expenses. The only downside will be to lose on some very low-interest rate.
The next kind of assets is your invested money. I am talking here about available investment account. We are not yet talking about money invested in retirement accounts. This should be mainly your broker account. But some people are also having online investment accounts such as peer-to-peer lending or real estate crowd investing.
These accounts are generally very liquid and you can include them in your FI net worth. If you invest in a smart way, your money will increase over time. It will also generate dividends over time. You can reinvest these or use them to cover your expenses. Their value can directly be used to sustain your expenses
However, you may lose some money depending on when you have to sell your investments. On the other hand, using the dividends to cover your retirement expenses is fine in retirement. To avoid having to sell at the wrong time, one technique is to increase the cash allocation before retirement. But some people do just fine without any cash at all.
Another great thing with these kinds of assets is that they have no limit. You can invest as much as you can (and want). They are your greatest asset to reach Financial Independence. This is especially true if you want to retire early. In that case, they are almost mandatory.
If you are serious about retirement, you should probably have some money in retirement accounts. This money is quite similar to your investment accounts.
These accounts should definitively be included in your FI net worth. They are really important for your retirement and financial independence. Since they generally have tax advantages, you should try to maximize your usage of these accounts.
There is one big problem generally with these retirement accounts. They are limited in how much you can contribute to it. There may be some countries where this is not limited. But most countries limit this since they offer tax advantages on them. That is why you need to complement them with regular investment accounts.
Moreover, you need to correctly account for the fact that these retirement accounts are not available today! They will be only available at the age of official retirement, sometimes a few years earlier. They are not doing anything for early retirement. That means that your other assets need to cover the time between your early retirement and the time you reach official retirement age.
If you want to be more precise, you could even calculate several FI net worth. You could have your current FI net worth and your future FI net worth that would include the assets that will be available at retirement. I am not doing that now. But this could you help visualize of what your net worth is made of.
Your real estate assets are part of your net worth. But they may not help you reach FI. And there may be several kinds of real estate assets in your net worth.
The most probable asset in your real estate assets is your own home. There is something really important about your own home! You need it. I do not think your own house should be part of your FI net worth. If you sell it, you need to buy a new one or rent another one. In the first case, you will not change your ability to retire. And in the second case, you may increase your expenses. In any case, you cannot simply take the value of your house into account to become financially independent!
If you have other real estate assets in which you do not live, they should be generating an income. In retirement, you can use that income to cover some of your expenses. That way, you need a smaller amount of net worth to retire. In that case, you should once again not take their value into account for your FI net worth. If you sell them, you will have more expenses to cover since your income will not cover them. Even if you own a two million home and live inside, this will not directly make you financially independent. You may be independent once you sell it though!
Even if your real estate assets are definitely part of your net worth, they should not be part of your FI net worth. If you sell them, the money will be part of the net worth, but it will make your FI number change. Selling your own house will likely increase your expenses. Selling a rented asset will also likely decrease your income and thus the expenses that you have to cover with your FI net worth.
I am not saying that real estate assets will not help you reach your FI number! Owning your home may highly reduce your yearly expenses. And owning a rental apartment can generate a lot of income and thus reduce your FI number. But once you have integrated these facts into your FI number, you should not count them in your FI net worth.
Some people take other assets into account when they calculate their net worth.
The best example of another asset is the car. Personally, I do not think anyone should include their cars in either net worth. They deprecate really too fast. And if you have a car, that means you need it. If you need, you cannot sell it. And if you sell it, it is also likely that you are going to buy another one. This will not increase your net worth. Actually, it will likely diminish your net worth. There are exceptions of course. If you own collectible cars, they could have a great value and could easily be sold back. But you should be very careful about the evaluation of the value.
Some people also account for their assets in their home. For instance, jewelry or computer. But jewelry is not a very good example. It is very difficult to resell jewelry at more than the value of the materials (gold mainly). At the instant you buy them, they almost directly lose value. Computers and electronics have the same issue. I probably bought for more than 10’000 USD of computers and electronics in my apartment. But I do not think I could get more than 2000 USD worth if I were to sell everything. I believe this should only be included in your net worth once it was sold. If you own something like a Picasso painting, you can probably add it your net worth. But I am guessing that you are not reading this blog ;)
There is another problem with assets like your car or a collection of valuables that you own. They may take a long time to sell. This means you will not have the cash available when you need it.
I personally do not think any of these assets should be included in either of your net worth or your FI net worth. They are not liquid enough and are losing value too quickly!
As you can see, there is more than meets the eye for the assets in your net worth. Not all the assets are equal. Some of the assets will help you much more towards Financial Independence than others. For instance, it is unlikely that your car will help you in retirement. Therefore, it is important to define your FI net worth differently from your net worth.
There are also some significant differences in some of your assets. The house you live in may help you reduce your expenses. But its value will not help you retire any earlier. Unless you sell it! And if you sell it, you can reassess your FI number. Even the real estate that you are renting has the same effect. If you sell it, you will have less income and your FI number will increase. Therefore, these assets should not be included in your FI net worth.
I believe this is an important concept that not too many people take seriously. Almost everybody agrees on what should be on the net worth. But there may be several kinds of net worths.
To learn more about Net Worth, learn how to compute your net worth.
What do you think about the FI net worth? Are there several kinds of net worth?