Net worth. It’s the be-all-end-all for benchmarking your financial progress. Or is it?
As useful as net worth is for tracking your finances, it also has some serious limitations. As a quick refresher, net worth is defined as:
Net Worth = Assets – Liabilities
Where assets are everything that you own (i.e. house, car, bank accounts, securities, rental properties, etc.) while liabilities are everything that you owe to others (i.e. credit card debt, student loan debt, mortgage, etc.)
The median net worth for all U.S. households is $97,290, based on the 2016 Survey of Consumer Finances. However, because net worth is such a broad financial measure, it can be hard to tell what that $97,290 is comprised of.
What is Net Worth Comprised of?
If you peek under the hood, you will see that, for many U.S. households, a significant portion of their net worth is the equity in their home.
The median home equity balance across all U.S. households is $36,000, which is a little over a third of the median household net worth. And older households have even more of their net worth tied up in their home equity.
For example, here is the median net worth by age:
And here is the median home equity by age:
If you run the calculations, you will see that the percentage of net worth made up by home equity is higher for older households.
For example, households aged 35-44 have about 20% of their net worth locked up in home equity while households 75 and over have closer to 46% of their net worth in home equity.
There is nothing wrong with this, but you can’t eat your home equity, can you?
When you need a decent chunk of change for an emergency outlay, you can’t pay for it with home equity. Yes, home equity lines of credit (HELOCs) do exist to make this possible, but HELOCs aren’t readily available for everyone and they can take time to process.
The same arguments I just made about home equity can be made about retirement accounts (i.e. IRA, 401(k), etc.) as well. Working adults cannot easily make withdrawals (nor should they) from their retirement accounts without taxes and penalties.
So, is there a better way to gauge financial security? Enter liquid net worth.
What is Liquid Net Worth?
Liquid net worth is the amount of cash you would have on hand after selling all of your liquid assets and paying off your short-term liabilities. Therefore, liquid net worth is defined as:
Liquid net worth = Liquid assets – short-term liabilities
In this case, liquid assets are all those assets that can be quickly and easily converted into cash (i.e. all financial assets outside of retirement accounts), while short-term liabilities are all those debts due within the next month (i.e. credit card balance).
This definition is very similar to the business term net liquid assets, and for good reason. Your liquid net worth should not include those liabilities that you aren’t expected to pay immediately (i.e. student loans, mortgage, etc.) just like it shouldn’t include assets that aren’t easily convertible to cash (i.e. home, retirement accounts, etc.)
Though some bloggers out there define liquid net worth as how much cash you would have if you sold everything immediately, this definition just isn’t realistic. Few of us will ever need to sell everything we own in a pinch (we are not Elon Musk).
And if we did go on such a fire sale, we wouldn’t call it liquid net worth, but liquidated net worth. The term “liquidated” better reflects the act of selling everything.
Why is Liquid Net Worth Important?
Now that we are on the same page regarding what liquid net worth is, you might be wondering why you should care about it at all.
You should care about your liquid net worth simply because it represents the amount of funds you can access under short notice.
- Need to spend $3,000 to fix your air conditioner? Liquid net worth.
- Want to be an angel investor in your friend’s company? Liquid net worth.
- Have to travel for a death in the family? You know the drill.
Liquid net worth is a far better measure of your ability to react to financial shocks and financial opportunities than net worth. Why? Because liquid net worth is based on what you have available right now. It’s not what you would have if you took drastic action and liquidated everything, but what you could reasonably expect to have in a short period of time.
What Does the Data Say?
Now that we have discussed liquid net worth and its importance, how much liquid net worth does the median U.S. household have? According to the 2016 Survey of Consumer Finances, the answer is $12,050.
However, after controlling for age, the median liquid net worth varies from $3,000-$50,000:
But still, this analysis isn’t all that relatable since we are grouping together all American households.
When we control for educational attainment and age, we can get a much better feel for what is going on (note: the y-axis varies for each subplot):
Now we can see that college-educated households are the ones with the highest liquid net worths, regardless of age. This doesn’t surprise me given that these same households earn higher incomes and are able to save more as a result.
What does surprise me is how little liquid net worth households without a high school diploma have. Even with increased age, the median household without a high school education barely has any wiggle room in case of emergencies.
Yes, I have heard that “61% of Americans couldn’t cover a $1,000 emergency expense directly from savings,” but it is still difficult to know that so many households are struggling to make ends meet.
Riches or Security?
With the coronavirus-induced collapse of the short term rental market, the difference between net worth and liquid net worth has never been more apparent. Airbnb entrepreneurs have realized that a cocktail of underutilized assets and excessive leverage can leave you with a nasty financial hangover.
Of course, no one could have predicted such a catastrophe ahead of time, but anyone who pursued riches in lieu of security now has neither riches nor security.
This is why you should be mindful of your liquid net worth in addition to your net worth. Because not all assets are equally valuable all of time. Sometimes a dollar on paper isn’t worth a dollar.
Thank you for reading!
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This is post 185. Any code I have related to this post can be found here with the same numbering: https://github.com/nmaggiulli/of-dollars-and-data