You don’t have to make a seven-figure salary to be considered a millionaire. Your net worth just needs to be worth at least a million dollars. But, what about your liquid net worth?
I once thought a millionaire was someone who made a million dollars a year. So, if you believe that, too, you are not alone!
In truth, a person can have a five-figure salary AND be a millionaire!
What is Liquid Net Worth?
First, we must define what net worth and total net worth is.
The net worth definition is the difference between a person’s assets and debt. Hence, calculating net worth is taking the total assets minus their debt.
Assets are anything that can convert into cash, such as stocks and real estate. On the other hand, debt is usually student loans, car payments, credit card balances, or any other credit card debt.
For example, the net worth calculation for $100,000 in assets and $40,000 in debt is $60,000.
Net worth = Asset’s Dollar Amount – Debt Dollar Amount = $100,000 – $40,000 = $60,000
The difference between net worth and liquid net worth is the type of assets! Liquid assets are assets that can liquidate to cash quickly. Therefore, calculating liquid net worth is the liquid assets minus debt.
In the previous example, the person had $100,000 in assets. However, if only $50,000 of those assets were liquid assets, then that person’s liquid net worth would be $10,000.
Total Liquid Net Worth = Total Liquid Assets – Debt = $50,000 – $40,000 = $10,000
What Are Considered Liquid Assets and Non-Liquid Assets?
Liquid assets are assets that can liquidate into cash quickly. If an asset cannot convert into cash quickly, then it is NOT a liquid asset.
Checking accounts, savings accounts, money market accounts, and cold hard cash are the purest forms of liquid assets. These assets are not tied to any market and will not fluctuate in value.
Bonds, mutual funds, and stocks are also considered liquid assets. They can be liquidated into cash quickly (usually within a few days).
They are not as liquid as cash because they depend on the condition of the market. However, stocks and mutual funds are more liquid than real estate.
Real estate is a large portion of my net worth.
However, investment properties cannot quickly convert into cash. It could take weeks to sell and close on a property, no matter how good a real estate agent is.
Also, depending on the market conditions, the actual purchase price could technically be below the property’s value. Furthermore, a person will have to pay capital gains taxes if they want to liquidate.
Add closing costs and additional fees, and the property simply won’t sell at its fair market value.
Cars are depreciating assets that lose value over time, especially within the first five years.
Anyone planning to purchase a used-car never expects to buy the vehicle at its original price. For this reason, I don’t include any of my cars as part of my total net worth.
Retirement accounts, such as a 401k or an IRA, are also considered non-liquid assets. However, a person can’t withdraw from their retirement accounts before the age of 59 1/2. Otherwise, there is a 10% early withdrawal penalty!
Once a person is of eligible age, then those assets become liquid assets!
Why Is Liquid Net Worth Important?
Net worth, in general, is an indicator of one’s current financial situation. For example, if someone were to have a negative net worth, it quickly implies that they have are not fiscally responsible.
The actual dollar amount of someone’s net worth may vary. Regardless, net worth is a wake-up call to let a person know where they stand and help them plan where they want to go!
Liquid net worth focuses on assets that can quickly convert to cash. Thus, liquid assets can supplement an emergency fund!
It is essential to have an emergency fund if there are significant repairs and medical expenses that insurance won’t cover. I recommend having at least three to six months’ worth of expenses.
If someone’s emergency fund is not enough, having liquid assets can provide that extra help!
How To Calculate Your Net Worth?
Gather all your retirement accounts as well as all your debt.
You can create a spreadsheet and do everything by hand. You can also do net worth tracking with Personal Capital.
Aside from tracking your spending, make sure you follow a budget!
I regularly meet with a financial advisor that helps me keep track of my financial goals. He has used different online tools over time. Below is a screenshot of my current net worth using AdviceWorks as of July 2020.
How To Improve Net Worth?
The two ways to increase one’s net worth is either increase assets or decrease debt.
Strive to contribute 10% to 15% of your income into investment accounts, such as mutual funds, IRA, and 401k. It’s best to start as early as possible to take advantage of compound interest. The value of an investment account can grow exponentially!
Compound interest is adding interest gained to a principal amount and then gaining more interest from the new principal amount.
The equity you own in a property, including your primary residence, counts towards your net worth. As the mortgage balance on the house gets paid down, then your equity in the property goes up.
Furthermore, the property value of the house will appreciate over time, adding more to one’s net worth.
With investment properties, specifically, Buy & Hold properties, the tenants pay down the mortgage balance by the rental income. Having five fully paid-off houses, each worth $200,000 is $1,000,000!
Get rid of all personal and student loan debt! The less debt a person has, then the more their net worth increases.
I had over $250,000 in student loan debt. It was surreal when I was finally able to remove that weight off my shoulders.
Debt Snowball Method
One strategy to reduce debt quickly is the debt snowball method.
List out all the debts and order them from the smallest balance to the largest balance, not including your mortgage. Check your credit card bills, student loan debt, and car loan debt.
Continue to make the minimum payments toward all the debts except the smallest balance.
Work towards paying off the debt with the smallest balance by paying more than the minimum payment. After you pay off the smallest debt, use that “extra money” towards the next smallest balance.
Additionally, a successful budgeting system can make sure one stays within their spending limits.
Extra Mortgage Payments
Once you remove all personal and student loan debt, you can start making extra payments towards your mortgage. Just making an additional mortgage payment towards the principal can shorten the term by five to seven years!
Refinance Your Mortgage
Another strategy is to refinance your mortgage with a lower interest rate. Refinancing a mortgage doesn’t reduce the mortgage balance. Instead, it reduces the interest due.
If a person can lower the interest rate by at least 0.75%, then it’s worth exploring!
However, keep in mind that there are closing costs associated with refinancing. A person would have to stay in their home for at least a certain amount of time to benefit from the refinance.
For example, a person has a loan balance of $150,000 with a current interest rate of 4%. The new interest rate is 3%, which is saving 1% in interest. Therefore, $1,500 is the amount of interest a homeowner will save a year.
Refinance Savings = (current interest rate – new interest rate) x loan balance
= (0.04 – 0.03) x $150,000 = (0.01) x $150,000 = $1,500
If the refinancing closing costs were $3,000, then the person would need to stay in the house for at least 2 years ($3,000 / $1,500).
Stocks vs. Real Estate: Which Is Better?
When building wealth or working towards financial freedom, some people tend to focus on one type of asset: stocks or real estate. However, it is essential to diversify one’s portfolio!
But, which is a better investment?
Imagine two investment properties, each with a market value of $200,000. That’s a real estate asset worth $400,000.
Furthermore, each investment property generates $2,000 in cash flow. That’s $48,000 a year in cash flow!
Annual cash flow = Monthly cash flow x 2 Houses x 12 Months
= $2,000 x 2 Houses x 12 Months = $48,000
Question: How much stock would a person need to have the same cash flow as real estate? For this, we need to do a little algebra.
Let’s assume a person will only withdraw 4% from their stocks each year to maintain their principal balance. Therefore, a person needs at least $1.2 million in stocks to have an annual cash flow of $48,000.
Annual cash flow = Annual withdraw rate x Stock principal balance
Stock principal balance = Annual cash flow / Annual withdraw rate
= $48,000 / 0.04 = $1,200,000
From the example, it only takes $400,000 worth of real estate to generate the same annual cash flow from $1,200,000 worth of stock. Also, rental income will rise over time, while the withdrawal rate needs to stay consistent to maintain the principal balance.
In the example, the real estate investments are performing three times better than the stocks. However, regarding liquidity, stocks provide a more significant lump sum than real estate. A person can receive the full market value of their stocks.
Not all assets are equally liquid. Real estate, cars, and stocks vary in liquidity. To calculate liquid net worth, take the liquid assets minus the debt.
One type of investment isn’t necessarily better than the other, which just all the more proves that diversifying one’s portfolio is very important.
The one thing that is key to success is time, whether that means paying down the mortgage or taking advantage of compound interest. Therefore, start building your wealth!