8—Calculating Your Net Worth

I told you there would be math

I’ve been upfront with you—these little articles will include some math (or at least understanding some basic math concepts and relationships).

But don’t panic or start thinking this is calculus-level stuff (although I’m sure some of you could handle it). It’s basic arithmetic, and trust me, it can seriously change your life (or at least your perspective).

Math is the language of finance; we have to get into the numbers. We’ll also dive into some real-life examples to make things clear. Why? Because understanding these ideas is a whole lot easier when you see them in action.

Let’s start with our first elementary example —we will predict someone’s net worth one year from now.

First, a couple of short definitions from Investopedia:

Asset: “A resource with economic value that an individual owns or controls with the expectation that it will provide a future benefit.”

Examples include home equity, real estate, cars, jewelry, stocks, bonds, and bank accounts.

Liability: “Something that is owed to another person, company, or government.”

Examples include home or car loans, taxes payable, credit obligations, parking tickets, etc.

With that, here’s what we’re working with:

• Assets: $50,000 earning a guaranteed 5% per year – Liabilities: $0 ( good for them) Note: I’ll discuss how assets like home equity fit in these calculations in another article, but that is not highly relevant to young adults just starting out.

• Net Worth: $50,000 (assets minus liabilities)

• Annual Income: $50,000

• Taxes: $4,000/year (est.)

• Living Expenses: $30,000/year

The Question: What will this household’s net worth be in a year?

The Answer:

Let’s break it down:

• Starting Wealth (Savings): $50,000

• + Income: $50,000 = $100,000

• – Taxes: $4,000/year (est.) = $96,000

• – Living Expenses: $30,000/year = $66,000

• + Interest Earned: $50,000 × 0.05 = $2,500 = $68,500

This household’s net worth (“wealth”) has increased by $18,500. $2,500 from interest and $16,000 from surplus income (after taxes and expenses) have added to the starting wealth of $50,000.

See? That wasn’t so bad; it’s really just adding and subtracting numbers. This example leads us to a simple formula, which I’m going to call our “Financial Life Equation,” or FLE:

Next Year’s Wealth = Current Wealth + Income – Taxes – Living Expenses + Interest Earned – Interest Paid

Or, if you like math symbols (and want to look smart and can figure out how to type a subscript—by the way, it’s in Format > Font Effects in Word for Mac and Format > Baseline in Pages):1

W_t+1 = W_t + I_t+1 – T_t+1 – C_t+1 + IntEar _t+1 – IntExp_t+1

Where:

• W = Wealth: A variable representing accumulated financial assets minus liabilities at the beginning of the period.

• I = Income: Income earned during the period (e.g., salary, wages, tips).

• T = Taxes: Taxes paid during the period, reducing net wealth.

• C = Living Expenses (a.k.a. Consumption): Consumption or expenditures also reduce wealth.

• IntEar = Interest Earned: Interest earned on financial assets, contributing positively to wealth.

• IntExp = Interest Paid: Interest expenses on liabilities, reducing wealth.

• t = current time

• t+1 = current time plus one year (t + n would be a variable, n number of years)

There’s no magic here—it’s just simple math. Most people think wealth is “what you save” after diligent budgeting. But saving is what’s left after giving (not shown separately as it’s assumed to be part of expenses), earning, spending, and paying taxes and interest.

(Some mathematical “magic” is part of the formula: compound interest. It’s the interest on the growth of our net worth year by year.” We’ll get into that later on when we discuss investing.)

This shows the importance of expenses, taxes, and interest, not just income, in the total net worth equation. The former are sometimes afterthoughts in the way that many people think about their finances.

This formula may be different from what you expected. Most people think of their future net worth as current wealth + savings:

W_t+1 = W_t + Savings_t+1

This relationship is true when savings are defined as:

Savings = Income – Taxes – Expenses + Interest Earned – Interest Expense, or symbolically as:

Savings_{t+ 1} = I _t+1 − T_t+1 − C_t+1 + IntEar _t+1 – IntExp_t+1

I’d like you to think of the savings equation this way: Savings is not something you do; it’s simply what’s left over after you earn money, pay taxes, give, pay for living expenses, earn interest, and pay interest.

If you have nothing left, then no savings. In that sense, savings = margin. If you have no margin, you will have no savings.

Some may say that margin = giving. I actually think I’ve said that before. And that’s also true to a point, but as you’ll see when we discuss giving in detail, I prefer to consider it an “off the top” expense, not what’s left as margin.

Let’s see how this works if we look out two years:

• Starting Net Worth (after 1 year): $68,500

• + Income: $50,000 =

• – Taxes: $4,000 =

• – Living Expenses: $30,000 =

• + Interest Earned: $50,000 × 0.05 = $2.500 = $87,000

This household’s new net worth at the end of the year has increased by approximately 21%. Things are moving in the right direction!

You can keep this going for as many years as you like, and the formula holds up. It boils down to this:

Future Wealth = Starting Wealth + Sum of All Income – Sum of All Taxes – Sum of All Living Expenses + Sum of Interest Earned – Sum of Interest Paid

The way that math textbooks express this in the formula is to use the Greek sigma Σ symbol for “the sum of” and N for a “variable number of years” and t+i = 1+N years:

W_t​+N = W_t​ + ∑I_t+i ​ – ∑T_t+i​ – ∑C_t+i​ + ∑IntEar_t+i​ – ∑IntExp_t+i​

Where:

• Your starting wealth is (W_t​)

• The sum of your income over the next N years ∑I_t+i​ (where i= 1 to N)

• The sum of your taxes over the next N years ∑T_t+i​ (where i = 1 to N)

• The sum of your giving and consumption over the next N years ∑C_t+i ​ (where i = 1 to N)

• The sum of your interest earned over the next N years ∑IntEar_t+i​ (where i = 1 to N)

• The sum of your net interest expense over the next N years ∑IntExp_t+i​ (where i = 1 to N)

Even though you will never use it, this, my friends, is the most critical formula to understand your financial life!

This also brings us back to an earlier article: We begin with our “starting wealth,” but other things (“levers”) contribute to determining your future wealth and are aligned to the “earn, save, spend, owe, give” model I shared earlier. So, let’s bring them together:

1. Your starting wealth (𝑊𝑡)

2. The total income you’ll earn over time (∑I_t)

3. The total taxes you’ll owe and pay (∑T_t)

4. The total money you’ll spend, including giving (∑C_t)

5. The interest (and growth) you’ll earn (∑IntEar_t)

6. The interest you’ll owe and pay (∑IntExp_t)

This basic math construct shows us that if we wanted to, we could calculate our net worth 50 years from now when we’re about my age.

It will be our current wealth + the sum of our income over the next 50 years – the sum of our taxes over the next 50 years – the sum of our consumption and giving over the next 50 years + the sum of our interest earned over the next 50 years – the sum of our interest expense over the next 50 years.

I’ll spare you the formula and a detailed description because nobody in their right mind would work it out using one (if the math and engineering majors want to, be my guest).

Plus, here’s the good news—some online tools are available to help you with this. Here are a few you might want to check out:

• Automated Net Worth Tracking: Empower

• Investing Integration: Betterment

• Collaboration with Spouse or Financial Advisor: Monarch Money

• Net Worth Calculator: Bankrate

• Budget Integration: YNAB (You Need A Budget)

If I were to recommend one, it would be Empower—formerly named Personal Capital. But many of you will also want to get some budgeting and investing tools. I’ll publish a separate article about tools (native and online) down the road.

Subsequent articles will discuss the six areas I listed above and how to understand, manage, and optimize them.

I don’t list giving because it’s not a financial “lever” in the sense that the others are, but it is a potent force in driving overall financial success. I’ll discuss why in the next article before discussing the six levers.

Some of what you will learn will be super actionable, while others will be more conceptual and involve understanding the big picture. Either way, you’ll improve your financial acumen and long-term financial health.