Financial Basics

The Net Worth Continuum: Wealth vs. Lifestyle

January 9, 2020 / Comments Off on The Net Worth Continuum: Wealth vs. Lifestyle

“Look at their house, they must be rich.” Before being able to learn about wealth, we have to understand what it is, and what it isn’t. Wealth is not the amount of money that passes through your hands or your bank account. It’s not a fabulous lifestyle either. While you may look around and see a lot of people living like they must be rich, the truth in the United States is that most families are funding that lifestyle with debt rather than actual wealth. This means they are getting further behind rather than getting ahead. Wealth is not how much you spend, it’s how much you keep. Wealth is measured as Net Worth, which is just a fancy word that means what you own, minus what you owe. 

Calculating Net Worth:

As I said, the calculation for your net worth is very easy math. Add up all of your assets, subtract everything you owe. Whatever is left: That’s your Net Worth. But let’s walk through a couple of examples.

Example: Joe

We begin with Joe. He is 26 years old and works as an electrician. Joe completed his apprenticeship with on-the-job training. After working for several years, Joe bought a small house in the same neighborhood as his parents. He drives a 10 year old pickup truck with 150,000 miles that he bought with cash last year. 

Is Joe wealthy? I’m sure he doesn’t think so, but let’s find out using our formula.

Joe has a net worth of $24,000. That’s far from being a millionaire, but it’s good progress in the right direction. How much does Joe earn at his job? We have no idea. Notice the amount of Joe’s paycheck is not part of the calculation.  You may think someone with a larger paycheck can accumulate more wealth, but that is not always the case.

Example: Beth

Let’s look at Beth. She is also 26 and went to the same high school as Joe. After graduation, Beth attended a four year university and graduated with a degree in engineering. Beth moved to Chicago, where she rents a nice apartment, drives a leased BMW, and likes to meet her friends at nice restaurants on the weekend. Last fall, she and her friends took a vacation to Cozumel. Is Beth wealthy? Let’s find out.

As you can see, Beth’s net worth is negative. She has no assets other than her bank account because she is renting both her apartment and her car. She has student loan debt from her degree and credit card debt from vacations and eating out. So in this fictional scenario, while Beth’s lifestyle might seem richer, Joe is the wealthier individual. We have no idea who earns more at their job, but Joe has clearly done a better job building wealth.  A rich lifestyle is not the same as building wealth. In fact, the richer the lifestyle, the faster it can erase your wealth. 

The Net Worth Continuum:

To further illustrate this, let me introduce you to something I call The Net Worth Continuum:

As you can see, your net worth is basically a number line with positive numbers in one direction and negative numbers in the other.

  • The neighbor pays you $15 to mow the lawn? Move your line 15 spots in the positive direction.
  • Spend $8 of that money on a movie with your friends? Move your line 8 spots in the negative direction. Where is the line after those two moves? At a net worth of seven bucks.
  • Spend those seven dollars on candy and a soda while you are at the theater and you’ll be back at zero, where you started.
  • If you want popcorn too and borrow $5 from your friend, your line is now at negative $5. You have nothing left of the money you earned, plus you owe your buddy five bucks. You are now at a negative net worth and will have to earn more money just to get back to zero. 

Earning and spending are pretty straightforward. Earning moves the needle in the positive direction; spending moves it in the negative direction. If you always spend every dollar that you earn, guess where your net worth stays: zero. If you spend more than you earn (which requires borrowing from somewhere), your net worth will be negative. So, as you can see, the very simplest way to build wealth is to save your money, rather than spending it. 

Debt & Investments: The Turbo Boost for Spending & Saving

You may notice in my handy visual aid that in addition to earning and spending, you can move the needle even further in the positive or negative direction by investing or borrowing. The turbo boost behind these activities is interest. In saving and spending, a dollar is simply a dollar. When interest is involved a dollar becomes MORE than a dollar, which can be a good or bad thing depending on which direction your arrow is going.

Investing means putting your savings to work to earn money for you. If I save $100 then my net worth is $100. If I take that money and put it under my mattress, a year from now my net worth will still be $100.  But if I take that same $100 and invest it to earn 10% interest, then in one year my net worth will have grown to $110, which is the original $100, plus the earnings ($100 x 10% = $10). My net worth went up and I didn’t even have to save more money! My investment was making money for me.

Sadly, the same is true for borrowing. Let’s pretend I spent all of my earnings and still wanted to buy an outfit. So I borrow $100 at a 10% interest rate. When I borrow the money and spend it, my net worth at that moment is negative $100. But over the next year, interest is accruing. Exactly one year later, if I haven’t made any payments, guess how much I owe? Yep. $110. So without spending any more money my net worth got MORE negative. Just like my investment grew by itself in the positive direction, my debt also grew on its own in the negative direction.

Why it Matters & What Now?

The formula for getting ahead financially is simple: spend less than you earn. But it’s the turbo charge of interest, especially compounding interest, that is really pushing you up and down the Net Worth Continuum. That’s why so much of the discussion around personal finance revolves around reducing debt and building wealth

Invest your savings to earn for you and you’ll finally understand how some of your friends and neighbors are quietly becoming Middle-Class Millionaires. Fund your lifestyle with debt and you’ll end up in the never ending cycle of using this month’s earnings to pay last month’s spending and needing to borrow again.

Knowing this basic truth and budgeting your life to follow it is the key to financial success. Measuring your net worth lets you know where you are, so you can see what you need to change to do better.

  1. Calculate your own Net Worth – Be honest…include everything you owe and don’t include ‘assets’ that aren’t valuable (clothes, video games, etc.)
  2. If your line isn’t steadily moving in the positive direction, figure out why. What are the debts and spending habits that got you here?
  3. Set a budget that moves your line to the right – and stick to it!
  4. Invest your savings (wisely)- Learning where you should put your savings is a whole other topic that people have written entire books about, but I promise to follow up with some basic advice on how to get started and how to find more information.

I’d love to hear how calculating Net Worth has changed what being RICH means to you!