Most people don’t calculate their net worth.  For those who do, it is somewhat of a guessing game.

Your net worth, technically speaking in a financial sense, is your assets minus your liabilities. If you own a car worth $20,000 with a $12,000 loan on it, then you get to count $8,000 for that one asset.

If you want to get a picture of how you’re doing financially, and where you are in terms of being able to retire, then it is probably better not to calculate your net worth in terms of everything you own.

Should you count your living room couch as part of your net worth?  What about your new smartphone?  What about your clothes?

They are all technically part of your financial net worth, but they don’t really contribute to your financial well-being in terms of being able to retire, unless you are planning to sell them.  These things contribute to your standard of living and enjoyment of life, but you shouldn’t be counting them as assets for the purpose of retirement planning.

Your couch and your clothes pay no interest to you.  You probably aren’t going to sell them, and if you do, they aren’t going to be worth very much.  You probably aren’t going to sell your smartphone unless you trade it in for another new one down the line, which will just reduce the expense of getting a new one.

I’m not telling you whether or not to buy a new smartphone or nice clothes or a new couch. I’m just saying that these things shouldn’t be considered as assets when planning for retirement or financial independence.  In fact, if you are planning to get a new phone every year when the latest model comes out, then this should be counted as a liability, as it means a higher cost of living.

It gets a little trickier with a car.  Most people need a car for transportation.  Most people also own a car that provides much more than just transportation.  If you buy a new $25,000 car, then it should be realized that you could have bought a new car for under $20,000, assuming you don’t need something large for transporting cargo or something where the type of automobile you drive actually matters for your occupation.

So I am hesitant to count a car towards net worth.  At the same time, if you own a $20,000 car with a $12,000 car loan, what happens if you take $12,000 from your checking account to pay off the loan in full?  Your checking account has been reduced by $12,000, but if you aren’t counting your car as an asset in your net worth line, then your net worth just went down by $12,000. This obviously isn’t right.

I don’t have an easy answer to this.  I think the easiest way is to calculate your net worth without counting anything that you aren’t going to sell.  This would include your car.  But you have to count the liability for your car (or anything else) in the negative column.  So if you owe $12,000 on your car, subtract $12,000 from your net worth without counting the value of the car.  It doesn’t matter if your car is worth $15,000 or $50,000.  If you aren’t going to sell, it makes no difference anyway. It may make a difference in the enjoyment you feel when driving, but it doesn’t make a difference to your financial net worth.  If anything, the more expensive car is more of a liability in terms of insurance and maintenance.

When you think about all of the junk that people accumulate in their house (you are probably one of them), it doesn’t make sense to value these things, especially when you aren’t going to sell most of it.  And for most of the things that will be sold, it will be a few bucks at a garage sale.

If you have something that is really valuable (a classic baseball card, a gold coin, a diamond ring) and you may potentially sell it in the future, then it is reasonable to count it towards your net worth.  Otherwise, forget about all of the junk in your house, and forget about things that aren’t junk if you don’t intend to sell them.

Your House

This brings us to the question of whether to count your home equity towards your net worth.  If you own a $300,000 house with a $160,000 mortgage, shouldn’t $140,000 go towards your net worth?

Even here, I would tend to lean the same way as above and say that you should only count it if you intend to sell it.

As with the car example, if you pay off your mortgage early, shouldn’t the added equity offset the amount that your checking account went down?

If you take $160,000 out of your checking account to pay off your $160,000 mortgage, your net worth is still the same.  It may start to go up more by not having to pay the interest on your loan, but that is your future net worth.

There are people who bought a house a long time ago in an expensive part of, say, California, who now live in a house worth a million dollars.  If they didn’t have the equity in their house, they wouldn’t be able to afford the house they live in.  Should they be considered millionaires by virtue of the fact that they have a million dollars in home equity?

If someone is planning to sell their million-dollar house and move to another area or rent, then certainly that million dollars of net worth will come into play, assuming the house value stays up.

However, if someone lives in a million dollar house and never intends to move, I don’t think it should really be counted towards net worth, at least when determining the state of the person’s finances and whether retirement is possible.

If anything, as Robert Kiyosaki would say, the house is a liability.  Someone who lives in a million-dollar house is paying much higher prices for insurance, upkeep, and property taxes than someone living in a house worth $300,000.  The insurance, maintenance, and property taxes on a million-dollar house will often be more than many people pay for their monthly mortgage payment.

Again, as noted above, it is better to just count the debt part against your net worth, but not count the value of the asset if you are never planning to sell.  Or in the case of a house, even if you are going to sell, you should only count the difference of what you will later buy.

For example, if you are going to sell your million-dollar house and buy another million-dollar house, then this will actually cost you money because of closing costs and commissions.  If you are going to sell and then buy a house for $700,000, then you can reasonably include $300,000 towards your net worth, minus the transaction costs.

Calculating FI

If you are trying to calculate a number for financial independence (FI), you also have to be strategic in how you count your home equity.

Many in the FI community like to say that you need approximately 25 times your annual expenses.  So if you spend $40,000 per year, you would need a million dollars to reach FI.  If you spend $100,000 per year, you would need $2.5 million dollars to reach FI.

I think the 25 times expenses formula is too low.  I find that many times the estimated returns that are counted on in the future are too high.  But that is beyond the scope of this post.

If you have paid off your mortgage, which is probably a good idea if you are planning to retire early or retire at all, your home equity should not be counted towards your net worth, unless you are planning to sell your house and move to a cheaper one. If you have a $600,000 house paid for versus a $300,000 house paid for, the person with the cheaper house is better off financially if neither one is going to sell.  The more expensive house is a bigger liability for maintaining.

The benefit of paying off your mortgage is that you won’t have the mortgage payment (principal and interest) as an expense.  So you don’t have to count that as part of your annual expenses, which can be a significant piece.

If you are going to pay off your mortgage sometime in the future and want to calculate your FI number, you can just deduct the amount you owe on the mortgage from your financial net worth.  But then you don’t have to count the principal and interest from your mortgage payment as part of your expenses when calculating your FI number.

So if you owe just $40,000 left on your mortgage and are trying to calculate your FI number, take $40,000 off of your net worth.  But you also get to take the principal and interest portion of your mortgage off of your expenses.

This is the way I would handle it.  It is ok to calculate your net worth to include your home equity, but you should also calculate it the way suggested above for planning purposes.  If you have any thoughts of your own to share, please comment below.