An investment strategy of using borrowed money to increase the potential return of an investment. An example would be to borrow money to purchase an investment property.
Emergency Fund
A personal budget set aside as a financial safety net for the possible future event that you lose your source of income or a large unexpected expense comes up. Most experts will say you need at least 3-6 months worth of living expenses saved up for a healthy emergency fund.
Capital Loss
A capital loss is when a capital asset (investment or real estate) is sold at a lower price than the purchasing price. There is a financial strategy called tax-loss harvesting that intentionally uses capital losses to offset capital gains so that not as many taxes are paid. Check out Stock Basics for a more in depth look how capital gains/losses are used.
Capital Gain
A profit that results from the sale of a capital asset (stock, bond, or real estate). The gain is the difference between the higher selling price and the lower purchasing price. Depending on the length of time that you have owned the asset will determine whether you are taxed on the profit as regular income or a lower capital gains rate. Check out Stock Basics for a more in depth look!
Side note: The sale of a piece of real estate can be considered capital gains if the money received isn’t spent towards other items. Contact your tax advisor if your are thinking about selling.
Net Worth
Net worth is a financial indicator that is calculated by taking your assets and subtracting your liabilities. This number gives you the state of your financial health and will let you know if you need to adjust your financial plans for the future. Check out Understanding Assets vs Liabilities & Net Worth for a more in depth look!
Liabilities
A liability is something a person or company owes, typically a sum of money. These can be broken down into current liabilities (which are paid back in less than one year) and long term liabilities (which are debts payable over a longer period). Check out Understanding Assets vs Liabilities & Net Worth for a more in depth understanding!
Assets
In the financial accounting world, assets represent the value of ownership that can converted into cash. Some examples are:
- Cash, Cash Equivalents (Stocks, Bonds, etc.)
- Inventory
- Property
- Equipment
- Trademarks
- Patents
Check out Understanding Assets vs Liabilities & Net Worth for a more in depth explanation!
Understanding Assets vs Liabilities & Net Worth
The rule of thumb is that you have reached financial independence when your net worth is 25x your annual spending. Or, to reverse it, your annual spending is 4% of your overall net worth. I call it the rule of thumb because while 4% is the general consensus on what defines financial independence there are many people who say you can retire sooner or later. Check out 4% Rule of Thumb Article for a more in depth look at where the 4% comes from.
So how do you calculate your net worth???
Net Worth = Assets – Liabilities
If you look at their core meaning; assets are the things you own and liabilities are the things you owe. Your net worth is a simple subtraction problem of your assets minus your liabilities.
Assets can be broken down in to two categories: appreciating and depreciating. Appreciating assets are things that gain value over time. For example, when you purchase your house the expectation is that its price will rise over time. Or your investment accounts at the where the overall value is increasing over time. Depreciating assets are things that lose value over time. A vehicle is the perfect example of this, according to CarFax.com a car can lose more than 10 percent of their value during the first month after you drive it off the lot!
Your net worth will include both types of assets but knowing the true value of each asset while it increases or decreases value will help determine your net worth. Even a pair of shoes can be considered a depreciating asset but things along that nature are typically not a part of calculating one’s net worth.
Some common assets are:
- Market Value of your House
- Market Value of your Vehicle
- Retirement accounts
- Checking/Savings Accounts
- Certificate of Deposits (CD’s)
- Real Estate
- Jewelry
Some common liabilities are:
- Credit Card Debt
- Mortgages
- Vehicle Loans
- Personal Loans
- Student Loans
- Boat, Lawnmower, motorcycle, ATV Loans
- Medical Debt
How do you Compare?
According to the Federal Reserve the average net worth by ages is as follows:
| Under 35 | $68,479 |
| 35-44 | $169,919 |
| 45-54 | $286,831 |
| 55-64 | $468,126 |
| 65-69 | $819,769 |
| 70-74 | $861,537 |
| >75 | $459,026 |
Now What?
Now that you are armed with the basics of assets, liabilities, and net worth how do you use that in your financial independence journey? This foundational knowledge will help you in three different ways.
- It lets you understand your current financial situation
- It provides a reference point for measure your progress towards FI
- What gets measured gets managed
There are lots of financial companies who are willing to assist you in managing your assets. Most of those companies will charge for those services and if you continue to read the articles on my website you will quickly find out that paying them for their services just isn’t worth it.
There are many free options out there where you can put all of your accounts in one location to look at the information. Some examples can be your workplace retirement account, brokerage companies (TD Ameritrade, Vanguard, etc.), and even some banks. You can also create your own Excel spreadsheet and track it that way. However, your Excel spreadsheet isn’t tied in to your bank account and requires a decent amount of work to keep it up to date.
I prefer to use Personal Capital. On the website you can keep track of your assets, liabilities, and follow your net worth in real time! They provide financial planning, tax optimization and advice that is specifically tailored to you. It also provides a free analytical tool which allows you to track your cash flow and helps keep you involved you’re your future. Use the link below to start building your foundation now! Affiliate link for Personal Capital.
“Out of sight, out of mind”
This statement could not ring more true to your financial performance. If you aren’t paying attention to your finances and continue to put yourself farther in to debt by taking on more liabilities then your goal of FI gets pushed further and further away. I get weekly e-mails from Personal Capital which informs me how my net worth has changed over the past week along with my spending habits and articles to keep me informed.
Take Away Points
- Assets are things that you own
- Liabilities are things that you owe
- Net Worth = Assets – Liabilities
- Tracking your net worth lets you know where you are
- What gets measured gets managed
Consumer Price Index
A measure that the Bureau of Labor Statistics (BLS) defines as the average change over time in the prices paid by consumers for a market basket of goods and services. This number is used to define the inflation percentage over time.
The CPI uses a base value of 100 for a given number of goods and services and uses the years 1982-1984 as its base years. The BLS then calculates what the same number of goods and services would cost each year. For example the Feb 2019 index (for all goods) was 252.776 and the Feb 2020 index was 258.678. By dividing the two numbers we see that the inflation in this 12 month period is a 2.3% increase.
Tax Deduction & Tax Credit
Tax Deduction
A reduction of taxable income. This number is subtracted from your adjusted gross income (AGI) and taxes are owed on the lower number. For 2020 the standard deduction is $24,800. The amount of taxes owed varies on your incoming. Check out Understanding the New (2018) Marginal Tax Bracket for more information and to find out how to estimate how much you owe in federal taxes.
Tax Credit
A reduction in total taxes owed.
Example
Let’s take a look at what the difference between a $1,400 tax deduction and a $1,400 tax credit would look like for a married couple filing jointly.
Before Deduction/Credit:
Adjust Gross Income: $80,000
Income Tax Owed: $6,284
$1,400 Tax Deduction
Income Tax Owed: $6,116
Difference: $168
$1,400 Tax Credit (Child Tax)
Income Tax Owed: $4,884
Difference: $1,400
You will receive $1,232 more for a tax credit than a tax deduction of the same amount.
