Revisiting Net Worth as a Measure of Financial Independence

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Financial independence means reaching a state where you generate enough passive income from investments to cover your expenses.

Monkeyism‘s central goal is to achieve financial independence. No longer having the pressure of needing to work for a salary means that you have the freedom to decide what you want to do with your time.

We previously discussed that everyone can achieve financial independence; you simply have to work hard, save money and let compound interest do the rest. When I showed how much you needed in order to be able to retire, I introduced the concept of net worth. This is an important concept that is worth understanding and I thus decided to explain it in greater detail in this post.

Net Worth

Net worth (sometimes also called net assets) is a financial concept that refers to the total of all your assets minus all your liabilities.

Here an asset is an economic resource that has a positive impact on your financial balance. For instance, a house or a savings account is considered an asset. This is because you can sell your house or empty your bank account to generate money.

A liability, on the other hand, has a negative impact on your financial balance. Most of the time, this means debts and ongoing payments. For instance, a mortgage is a liability because it generates negative income.

Thus, computing your personal net worth means listing all your assets and liabilities as follows:

\textrm{Net Worth} = \textrm{Total Assets} - \textrm{Total Liabilities}

1. Negative Net Worth

Although most of us would prefer to avoid this situation, it is actually very common. It means that even if you resell everything you own, you will not be able to reimburse all your debts. This may happen, for example, if you buy a house on a mortgage.

This may surprise you, so I will explain how this works: The total cost of the mortgage usually exceeds the market value of the property because of the interests you pay. The terms of the mortgage generally tie you into paying this interest with little room for exit manoeuvres. So what’s the impact of negative net worth?

The good news is that negative net worth does not equate bankruptcy. The bad news is that you continuously need to add assets to your balance in order to keep your finances afloat. Practically speaking, it means that you will need to keep a stable salaried job. As you will not be able to cover all of your debts with your current assets, you become dependent on this income and have little choice but to continue working.

2. Positive Net Worth

Conversely, having a positive net worth brings you one step closer to financial independence and early retirement; it is a necessary but not a sufficient condition. Positive net worth means that all your debts could be paid off by selling your assets. Of course, in order to actually retire early, you will need your assets to significantly exceed your debts.

The real question thus becomes how much positive net worth you need. In our prior examples, most of our positive net worth came from liquid assets i.e. cash. This is the ideal case scenario and was done purposely to illustrate how you can reach financial independence.

Liquid assets are ideal because they can be reinvested and generate passive income. However, often positive net worth is tied to physical assets. For instance, you may have a positive net worth of $1 million – But if your asset consists of a house in which you are currently living, you are unlikely to be financially independent because you do not have any income generating assets.

On the other hand, a net worth of $1 million which contains a property ($300,000) and an interest-generating savings account ($700,000) may set you free from salaried work. It is all about how you balance your portfolio.

Net Investment Wealth

Keeping in mind that not all assets can generate income, we need a more granular indicator to help focus on income-generating assets. I thus suggest that you calculate the net investment wealth as follows:

\textrm{Net Investment Wealth} = \textrm{Net Worth} - \textrm{Lifestyle Assets}

Lifestyle assets are things you own that are necessary for you to live but do not generate any revenue, for instance a main house or a car. To achieve financial independence, you need to have a high net investment wealth that will allow you to receive enough passive income to cover your daily expenses. This is the net investment capital you can use.

There are two ways to maximise your net investment wealth:

  1. Reduce your liabilities
  2. Reduce your lifestyle assets

Having a large positive net worth is the first step. Rebalancing your assets by focusing on income-generating ones is the second step. In other words, being rich does not necessarily mean being financially independent.

You could spend all your money on status objects and not be able to generate any passive income from your assets. For instance, a family with the following financial summary may look well-off on the surface but is far from being financially independent:

Assets
Assets Value
Liabilities
Liabilities Value
Total Assets$1,360,000Total Liabilities($610,000)
Main Residence$700,000Mortgage($300,000)
Car$40,000Car Loan($20,000)
Investment Property$500,000Investment Loan($250,000)
Investment Portfolio$100,000Deferred Capital Gain Tax($30,000)
Savings Accounts$20,000Credit Card($10,000)

\textrm{Net Worth} = \$1,360,000 - \$610,000 = \$750,000

\textrm{Net Investment Wealth} = \$750,000 - (\$700,000 + \$40,000) = \$10,000

Although this family has a high net worth, it is all tied up in lifestyle assets. They only have $10,000 of net investment wealth that they could use to generate additional income. The rest of their assets either do not produce any income or are already offsetting debts.

If this family wanted to achieve financial freedom, it should focus on becoming debt-free and maximising its share of income-generating assets. Lifestyle objects would become secondary.

This means they would move to a cheaper house and exchange their car for a low-cost model in order to repay some of their debts. Not everyone will want to do this, despite the obvious benefits:

Assets
Assets Value
Liabilities
Liabilities Value
Total Assets$1,080,000Total Liabilities($330,000)
Main Residence$200,000Mortgage($50,000)
Car$10,000
Investment Property$500,000Investment Loan($250,000)
Investment Portfolio$100,000Deferred Capital Gain Tax($30,000)
Savings Accounts$270,000

\textrm{Net Worth} = \$1,080,000 - \$330,000 = \$750,000

\textrm{Net Investment Wealth} = \$750,000 - (\$200,000 + \$10,000) = \$540,000

Thus, although they have the same net worth as before, this family would now have $540,000 in net investment capital. With a return on investment rate of 5% per year (e.g. using high-interest savings accounts), they would earn $27,000 a year in passive income. As they already own their main residence and assuming they spend $3,000 per person on food each year like we do, they would already be well on their way to financial independence!

Whether or not you end up financially independent is down to the choices you make. Be smart with your money – It could save you a lot of time!

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Monkey Master

My wife and I are currently living in Sydney, Australia. We plan on becoming financially self-sufficient in 2015 so we can retire at 35. We are regular working people, trying to be smart about saving money and generating passive income. I want to share with you how we reached that decision and how we are planning towards financial independence. Continue Reading.
Contact: monkeymaster@monkeyism.com

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