When people discuss about building wealth and increasing the net worth the first thing that is typically brought up in discussion are strategies for saving, investing, and watching your spending habits. But what is often forgotten is the other 50% of the net worth equation, the liabilities. Remember that net worth is simply the sum of all your assets minus the sum of all your liabilities. In a simple formula, Net Worth = Assets - Liabilities. So yes of course, you can increase your net worth by adding to your savings account for example. But you can have the same effect on your net worth and often times a bigger effect by paying down debt faster. We may be often fooled by others who seem to have a strong image of success and a high net worth, but often times this person may have a massive amount of liabilities to their name and a potentially negative net worth in fact.
It is another common misconception that net worth ranges on a scale from 0 to infinity. But in reality, net worth is on a spectrum from negative infinity to positive infinity. Millions of consumers have a negative net worth where their liabilities outweigh their assets and THAT’S OK. You are still increasing your net worth if you go from a negative number to a smaller negative number (i.e. closer to 0). Let’s take a look at an example:
Gary has a checking account (cash on hand) of $1,500 and a savings account of $4,000. He also has a retirement fund that is currently worth $20,000. Gary does not own a house at this time and therefore has a total sum of assets of $25,500. As for liabilities, Gary has an auto loan for $12,000, a student loan for $26,000, and revolving credit card debt of $2,500 for a total liability burden of $40,500. In this scenario, Gary’s total net worth is -$15,000. This is where the question comes in of savings versus paying debts and why it’s often recommended to reduce debts first.
With a negative net worth of -$15,000, let’s say Gary has another $500 to either save or pay down debt each month. Say that he goes ahead and saves it so that after 12 months he has $6000. Assume a 1% average APY for a savings account and Gary will have made about $28 in interest for a total net worth gain of $6028 over the course of those 12 months. With all else equal, Gary’s net worth at the end of the 12 months would be projected to be $8972. Obviously a lot can change with his other assets and liabilities but let’s assume everything else is static. Now let’s see what happens if he pays down debts with the extra $500 instead.
With Gary's debts, it is important to know just how much interest is actually accruing. Let’s say Gary is making the minimum monthly payment towards all his debts. Assume the interest rate is 5% for the student loan, 6% for the auto loan, and 17% for the credit card debt. Assuming 5 years left on the student and auto loans, once they are finally paid off, Gary will have spent approximately $8341 in interest. This represents a huge drag on Gary’s ability to increase his net worth. Now let’s say Gary applies the $500 a month to his debts using the typical snowball method (paying off debts with smallest balances first). First Gary will apply the $500 to his credit card debt and should be able to pay it off in 4 months with a total interest amounting to $111 (compared to the $2,982 he would have eventually paid by making minimum payments) and with the remaining 8 months he would keep paying off his student loan. If Gary continues on this path over the next 12 months he will have only paid $2257 in interest. This represents an additional $6084 to his net worth over time simply because he decided to pay his debts down first. While this example is a bit lengthy, the key thing to remember is this: If the interest rate on any of your debts is higher than the % you can gain from your assets, you should always pay down your debt first with the exception of mortgages. This rule almost always applies when comparing the rate at which you accrue interest on your debts versus the rate at which you can accrue interest on assets, which is often always the case. The reason we make an exception for mortgages is because mortgages are unique in that you are also paying for the equity in your house which is counted as an asset (and often appreciable unlike automobiles) over time. Natural inflation will also favor the borrower in these cases because it may meet or exceed the interest rate at which you are paying the mortgage off. Another key point to remember is that while it is better to pay down debts faster, it is also important to have an emergency fund of at least $1000 that serves as a cushion against any unexpected expenses that may cause you to potentially incur more debts. Feel free to reach out or check out our other resources related to mortgages on our blog.
While we went into a great deal of detail demonstrating how paying down debts can drastically increase your net worth over time (even if you are going from negative to 0), we’ve also made this easy to show you how much interest you’re paying currently on your debts and the amount of savings you can achieve and add to your net worth on our platform’s debt management tools. It automatically calculates the total amount you’ll be saving in interest by paying down debt faster. In Part VI of our series “How to Build Wealth from Nothing,” we’ll be discussing how to go about saving your money after paying down your debts.
Harvest helps increase the net worth of the 99% through artificial intelligence and financial automation. To date, Harvest has refunded over $2M in bank fees and interest charges to its members with the ultimate goal of increasing the net worth of everyday Americans by $1 trillion by 2030. Our platform starts with providing immediate relief through bank fee and interest charge refunds, orients a member's financial health with our proprietary PRO Index™, and keeps track of net worth over time aided by our suite of financial tools. Check out our 8-step guide on "How to Build Wealth from Nothing" to get started on increasing your net worth.