One of the most important steps you can take toward reaching financial independence is to measure your progress. But what, exactly, should you measure?
Let's start with your net worth. That single number, computed and tracked regularly, has the power to tell you if you're headed in the right direction or not—in other words, whether you are becoming more or less financially independent. Armed with that knowledge, you can then make course corrections to get yourself there quicker.
What, precisely, is net worth? It’s defined as the amount by which your assets exceed your liabilities. Assets are the things and sums you own, and liabilities are the sums you owe. If you own more than you owe, then your net worth is positive. And that’s the direction you need to go in to reach financial freedom.
In my experience, the act of monitoring your net worth regularly is more important than the number itself. That’s because computing and tracking net worth teaches you, in simple and direct terms, whether your financial activities—working, saving, borrowing, spending—are leading you in the right direction or not. It also tells you whether your financial choices—career path, home ownership, investments—are actually paying off for you.
Simply put, your net worth needs to grow in most years, which indicates you are living below your means. If your net worth stays the same, that means you aren't saving and will have to work indefinitely. Worse yet, if your net worth goes down for very long, you are digging a hole that will be difficult to escape: You could be headed for a lifetime of indebtedness to others.
If you use software such as Quicken or Mint.com, then an estimate of your net worth is probably available from an easy overview screen or report. But it's good to know how the software is computing that number, and to be able to do it yourself. Even if you don’t use software to track your accounts, you can still compute your net worth in a matter of minutes, using a sheet of paper and a hand calculator.
Start by adding up the values of all your checking and savings accounts. These are some of your assets. Next add in the current value of any and all investment accounts. If you have any retirement accounts, add those in too. (I discuss how to value Social Security in this article.) If you are married, then include the value of your spouse's accounts; you are actually computing your net worth as a couple.
Next, add in the value of significant personal property, such as vehicles and your home. You’ll need a fair market value for those items. For vehicles, I use NADAguides.com. For houses, I use Zillow or eppraisal.com. Be advised that online estimates are only rough approximations. But they should capture major market movements, which is your main interest.
If you have a mortgage or auto loans, you then need to subtract the outstanding balances on those loans, which are liabilities. Finally, subtract any other debts such as credit card or student loan balances.
When you are all done, the number on the bottom line is your net worth.
If you've never computed your net worth before, you could change your financial life by starting right now. Make a simple 2-column table. (A computer spreadsheet is the best tool, but paper will suffice.) At the top of the table list your assets in the first column and their values in the second. Next list your liabilities. Just estimate any values that you can't grab easily, don't get bogged down in research this first time through. Then add up all the assets, subtract all the liabilities, and post your net worth, along with the date, at the bottom of the table.
Here is a simple example:
|Vehicle Market Value||$15,000|
|NET WORTH [9/2014]||$31,000|
Finally, make a note on your calendar to compute this number again in about three months. You can refine the table and its values over time, but you've just taken a very important first step to measuring, monitoring, and achieving financial independence. Keep an eye on your net worth during all your working years, and it will steer you to financial freedom!
Darrow Kirkpatrick is a software engineer and author who lived frugally, invested successfully, and retired in 2011 at age 50. He writes regularly about saving, investing and retiring on his blog CanIRetireYet.com. This column appears monthly.