Thursday Jul 31, 2014

The key performance indicator that matters in personal finance

5 September 2011

Some bloggers may argue that debt is a huge problem and that it’s repayment must be the only focus in personal finance. Some others may keep blogging about the virtue of saving for all your needs, even when it keeps you from paying off your debt. Personally, I don’t really care much about these specific issues. To me, the only personal finance indicator that matters over the long term is net worth.

Looking at the big picture

When you make a financial decision, you should always ask yourself: “if I take option A over option B, what is the effect on my net worth over the long term? One year from now? Five years from now?” The option that has the most positive impact on it is often the right thing to do. When you only think in term of specific indicators or ratios, like the amount of debt you owe, you’re missing the big picture.

Let’s take an example: should you borrow money to invest in an RRSP? Someone who thinks the only way to get richer is to reduce his debt level will definitely say no. In fact, the tax return on your contribution is an immediate increase in your net worth. A $5,000 RRSP loan (increase in debt) will lead to a $6,550 increase in assets at a 31% marginal tax rate. Over the long term, the difference between the potential return on your investment and your borrowing cost will produce an additional increase in net worth. Borrowing for your education is another good example of leverage, where a few thousand dollars in short-term debt may double up your net worth at retirement.

The same logic applies to savings. As I already discussed here, there’s no point in saving money at 1% or 2% rate when you pay high interests on loans. Have access to a line of credit in case of emergency and pay off that high interests debt first. The key is always what return you can get on that extra dollar of yours. Investing in that savings account can be a smart choice in appearance but in reality, you end up a few hundred dollars behind a few years later.

How do I calculate my net worth ?

The basic formula is quite simple: subtracting all your debts from your total assets. It’s always important when calculating your net worth to be conservative, and here are some tips to do so. Evaluate your home or car as if you had to sell it very fast. You would probably not get the perfect sale price if you had to do so, and it could happen in real life. You might as well deduct all the commissions or fees you would normally engage in the sale of your home. Most experts agree that you should never consider your furniture when calculating your total assets. It loses value over the time and you often have to renew it when you buy a new house. Do not forget any other obligation that could be considered as a debt.

Now start keeping track of your net worth. Do it on a yearly basis because expenses such as property taxes or revenues such as a bonus are not equally distributed throughout the year. At the same time, stay comfortable with your debt level and the risk level of your investment portfolio. Did your net worth increase since last year?

 

 

About the Author

Francois Mathieu

Francois is an Analyst at Desjardins Group. A hockey fan for his beloved Habs. He views himself as an internet junkie for business/tech related news.

Comments (2 )



I agree about your long-term measure being net worth. However, to someone drowning in debt, net worth is a foreign term. To someone that is seriously in debt, I do believe that the amount of debt is the best measure. It allows them to set and attain goals.

At the point where one can start saving – not necessarily when all of their debt is paid off – net worth is a better gauge and motivator.

[Reply]

Francois Mathieu Reply:

When somebody is drowning in debt, he probably doesn’t benefit from preferred rates, as lenders fear for default. High interest debt repayment is a move in the right direction for long term net worth increase.

[Reply]

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