The Net Worth Payment
For personal finance DIY’ers, trusting the long term effects of financial decisions can be difficult. Even when everything makes sense on paper, it isn’t always easy to know if we’re making the right call, financially. Markets can rise and fall. Investments can spoil. Dreams can change. As we progress through the long term unknown, the decisions we make in the meantime will likely shine or dim along with the changing conditions.
Despite the odds, it’s always a good idea to orient your investments and savings towards the goals we have, if at least for now. It’s also wise to check on these goals and the progress made from time to time. So long as the goal remains in place and the progress remains healthy, this can create a remarkably peaceful feeling among the uncertainty.
But what if our goals are less clear? Also, what if we are too young to galvanize long term goals? After all, it’s difficult to know exactly what we’ll want in retirement when we’re still young. Also, for those facing tough transitions in life such as illness, death, divorce, job change, suddenly the goals we had in place maybe aren’t so clear. Or at least put on hold.
The good news is, there is help.
Later in this piece, we’ll look at a very general way to measure your financial progress. Before we get there, let’s talk ratios.
Personal finance ratios can help us when our financial goals are less clear. They help answer the question, “am I saving enough?” or “am I spending too much on a house?” They operate as an answer to common concerns absent any other financial input.
Probably the most useful part of these ratios is the elimination of comparison to others. That is, when trying to decide how much house you can afford, one of the most compelling influences can be the types and values of homes owned by peers. The wonderful thing about ratios is that they can help you disregard unhelpful social comparisons and measure your financial ability and progress independently. Let’s look at a few of the most commonly referenced financial ratios.
Common Ratios
The 50/30/20 budget rule: The broadest popular financial ratio.
This idea attempts to advise, generally, how your spending should be allocated in your budget. First, it recommends that 50% of your spending should go towards needs (housing, groceries, utilities, health care, debt payments, etc). The next 30% should go towards wants (eating out, vacations, discretionary spending, etc) and the final 20% towards savings (emergency fund, retirement, general savings).
Emergency Fund Ratio: Do you have enough to weather the storm?
This ratio helps advise us how much we should have set aside for a rainy day. Unlike the 50/30/20 rule above, this ratio does not have the benchmark built into the title. The benchmark, as typically advised, is 3-6 months worth of total expenses set aside and used only for emergencies such as unemployment, large home/car repairs, or unexpected medical bills. Variations on the 3-6 month benchmark usually stretch the goal to 6-12 months for self-employed or those in volatile industries. Also, some users choose to cover only fixed mandatory expenses with the idea that discretionary spending can be paused if needed.
Savings Ratio (AKA Savings Rate): Are you saving enough every month?
This ratio suggests putting away 20% of your gross income towards savings. This can be retirement savings, general savings, or investing in a liquid brokerage. The nice thing about this goal is that it overlaps nicely with the previously mentioned ratios. Remember the “20” in the 50/30/20? Also, saving 20% of gross income can fill up your emergency fund very quickly.
Debt to Income ratio: Can you handle your debt payments?
This ratio helps you weigh whether or not too much of your income is being put towards debt payments. The calculation is relatively simple. It is your total monthly debt payments divided by your gross monthly income. Once you have your number, compare it with the benchmark of 36%. Any higher than 36% and you may have too much debt relative to your level of income. Anything below the benchmark indicates that you’re on the right path. The lower, the better.
Housing Ratio: Did I buy too much house?
Nested within the debt to income ratio, is the housing ratio. I say that because our mortgage (debt) payment is included in our total debt payments used above. However, if we isolate our mortgage debt payment and divide it by our gross monthly income, we get our housing ratio. The benchmark for this ratio is 28%. Once again, the lower the better.
If you’re meeting every benchmark above, you’re probably in great shape, or you will be before long. However, remember when I said these ratios exist minus any other financial data? That is because they intend to serve as general rules of thumb rather than curated financial advice. How you choose to apply these ratios depends on your individual circumstance and your benchmark may be wildly different.
For instance, for a young couple seeking F.I.R.E. (financially independent retire early), the savings goal of 20% may be way too low. They may push as high as 50% or higher in their pursuit of early freedom.
Likewise, young parents who find a home next door to a perfect elementary school, a few miles from grandparents, and within a desirable community, perhaps won’t be as worried about a 28% housing ratio. If they are both expecting rapid, stable income growth, maybe stretching this ratio in the short term isn’t a concern compared to the invaluable benefits.
And finally, what about those who saved aggressively and find that their dream retirement is already funded, along with a healthy emergency fund? Should they still worry about saving 20% until they eventually retire?
Asset to Liability Ratio
If you find yourself reasonably questioning how one or more of these ratios apply to you, then perhaps taking a step back and viewing the larger picture may help.
This is where your asset to liability ratio comes in. This ratio simply measures how much you own compared to how much you owe. It is calculated by dividing your assets by your liabilities. In layman’s terms, take everything you own and divide by all of your debt. Your assets include your savings, investments, home value, car value, jewelry, and anything else you possess. Yes, even if you have debt taken out against them (mortgage, etc). The debt is simple. The balance of everything you owe.
An asset to liability ratio of 1 indicates that you have just as many assets as liabilities. This may sound good, but it is a tipping point in either direction. You can quickly slide below 1 or compound your way higher. The standard benchmark for this ratio is 2 and beyond.
Your Net Worth
Your asset to liability ratio strongly correlates to your net worth. Since your net worth is your assets minus liabilities, an asset to liability ratio of 1 indicates that you have a net worth of $0. See? Not so good. Even worse, an asset to liability ratio of less than one indicates a negative net worth and possible trouble ahead.
Tracking your net worth
The great thing about net worth is that it can be very valuable in a few different ways. Primarily it acts as a snapshot of wealth. It is value of everything you actually own. Or as I put it in “Principles of Prosperity” what you would have left should you sell everything and live under a bridge.
What I like about tracking net worth is that it can be an indicator of financial growth independent of financial ratios. Even if you aren’t meeting the benchmarks above, you can find comfort in consistent net worth growth. In other words, even if you aren’t doing everything right, you’re likely doing something right.
The net worth payment
As we assess the bigger picture far above the ratios, you can measure your progress in a few ways. Of course, monitoring your net worth every month or so is a good start.
However, as we decide from month to month on savings, debt payments, and so on, there is another unique way to perceive how your decisions impact your overall wealth. That is to factor your net worth payment.
In the simplest form, your net worth payment is every dollar saved (doesn’t matter if it’s savings, 401k, IRA, etc) plus the amount of debt payment that is applied towards principal.
Savings + Debt Payments Applied to Principal = Net Worth Payment
Admittedly, “debt payments applied to principal” doesn’t sound like a fun chore. Don’t let it scare you. On your mortgage statement, you can usually find it under the payment breakdown. For other loans, you might have to do a little math. If you divide the interest rate by 12 and multiply it by your outstanding principal, then you have the amount paid to interest. From there, just subtract it from your payment and you’ll have the payment applied to principal! (For mortgages, make sure to exclude any escrow amounts)
Let’s say Joey wants to find his net worth payment. Here are his details
$1,237 paid towards mortgage principal as reported on his mortgage statement.
$400 saved in high yield savings
$100 saved in an HSA account
$550 saved in a 401K
$223.75 ($250 payment made on a 5.25% car loan with a $6,000 principal balance)
$63.92 ($75 payment made on a 13.99% credit card with a $950 principal balance)
Added together, Joey has a net worth payment of $2,574.67. This is the immediate effect of these payments on Joey’s net worth. Absent any change in investments or home value, Joey’s net worth will immediately improve by over $2,500 from these payments.
Notice we didn’t say anything about ratios? He can certainly check ratios, but if some or any don’t apply to his situation, at least knows the power of his net worth payment
Extra Credit
If you want to be even more accurate, feel free to add interest and dividends earned from savings and investments. After all, if reinvested, those are payments that immediately impact net worth as well.
Still want more? If you decide to add payments on top of minimum debt payments, you can calculate the extra interest saved and a present value of all future saved interest payments. Now we’re talking. Reach out to ask how.
By adding these advanced ideas, you can begin to play around with how putting more money towards different savings and debts can affect your overall net worth. Is money best spent towards a low interest rate mortgage or a high yield savings? These advanced steps can help.
Need a Benchmark?
Figuring your net worth payment and tracking your net worth is a great way to capture a comprehensive snapshot and your progress. For those wanting a benchmark regarding net worth growth, there are a few ideas out there.
Keep pace with inflation: This is a baseline goal, ensuring your net worth isn’t shrinking as compared to overall price inflation
Pick your index benchmark: If you’re more investment-minded, picking a stock index and attempting to match annual returns to your personal growth might be a good idea. This idea also provides some grace in down market years. If much of your wealth is invested, watching your net worth decline despite significant net worth payments can be frustrating. Comparing to stock returns can paint a more reasonable picture.
10% annual: If you’re a generalist, 10% annual (or ~ 0.83%/mo) growth may be a reasonable goal. Just remember that this may be too low early in life. Likewise, in later years when your net worth is high, matching this goal may be unreasonable.
Progress is Progress
The ratios I mentioned above are just a glimpse of the financial rules of thumb out there. Using these (and others) to see how you measure up is a great way to spot deficiencies or something you’ve been neglecting. However, don’t forget to step back from time to time and acknowledge the growth you have achieved. After all, enjoying our success from time to time may be the encouragement we need, even if our housing ratio isn’t perfect. The net worth payment is here to help.
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