Having a clear understanding of your present financial situation is absolutely essential if you hope to map out a plan for achieving future financial goals. You can get a good handle on where you are now financially by very simply using two blank pieces of paper to prepare a couple of fairly straightforward statements: a Net Worth Statement and an Income & Expense Statement. In this segment, we’ll cover the Net Worth Statement, and in Part II we’ll cover the Income & Expense Statement.
Creating a Net Worth Statement
1. Take a piece of paper and draw a line down the center of it.
2. In the left column, write down the value everything you OWN. These are your assets.
3. In the right column, write down the value of everything you OWE. These are your liabilities.
For example, you would write down what you think that your house would sell for today in the left column, and then write the current balance of your mortgage in the right column. (Note: it might be helpful to jot down the terms for a loan like the interest rate, years remaining, etc.)
Continue this process until you’ve created a meaningful tally of your assets and liabilities. Assets would include home values, savings accounts, investments, 401ks, IRAs, stock options, collectibles and other assets. Liabilities should include mortgage balances, home equity line of credit balances, automobile loan balances, other loan balances and credit card balances.
Tally the Amounts
Tally the sum of your assets in the left column, and tally the sum of your liabilities in the right column. You can then calculate your Net Worth by finding the difference between the sum of your assets and the sum of your liabilities. This is a snapshot of where you are today. Take a few moments to review this statement and think about where you’d realistically like it to be in five years, ten years, or twenty years. There are certain things that should jump right off the paper at you. Let’s take a closer look.
Do you have three to six months worth of living expenses immediately accessible to you in the event that something unexpected happens (e.g., short-term disability, lay-offs, emergency home repairs, etc.)? Perhaps, shoring up your emergency savings should be a short-term priority if you sense that this is deficient.
Are You Using Debt Constructively, Or Are You Using It Destructively?
An example of the constructive use of debt might be the reasonable mortgage you have on your home that frees up cash for use in pursuing your other priorities. The mortgage interest is usually tax-deductible and the rate of interest charged is generally the best you can receive for any asset that you pledge as collateral.
How about the destructive use of debt? Is there a large amount of cash sitting in a bank account idly and without purpose earning nearly 0% interest while you carry a sizeable credit card balance having a 12% or greater interest rate? Or, does the credit card balance continue to grow and grow, because you might be unwittingly spending your money on frivolous purchases?
How Liquid Are Your Assets?
Let’s review your Net Worth Statement from a different perspective by focusing on your assets. Have you potentially painted yourself into a square corner by aggressively paying down your mortgage? This is known as being house rich and cash poor.
Do you have enough in retirement savings? Or, do you have too much in retirement savings subject to penalties for early withdrawal? You might find yourself having to take an early distribution from your retirement savings with a 10% penalty when there are insufficient taxable savings. Having the appropriate mix of taxable savings and retirement savings is an important part of financial planning.
In our next segment, we’ll cover the Income & Expense Statement as part of the “Where Are You Now?” step in the process. In the meantime, please contact Leo if you might be interested in learning more about engaging the services of a CFP® professional.