Building your financial power doesn’t have to be complicated, although for many of us it’s a mystery. You earn money from work, spend most of it, and then hope for the best when it comes to paying for higher education and retirement. Looking at your personal balance sheet at least annually informs your progress toward your goals. Do it for a few years and you’ll see your financial standing is fed by four major sources. Most pay attention to one or two of them, but by considering all four you can build a sound financial future.
Before we explore the four sources, consider what we mean by balance sheet. If you remember your accounting class, a balance sheet tabulates assets and liabilities. This applies to corporations and households alike. To calculate yours, first add up your assets. Include the value of your home, a realistic value of cars and other significant property, retirement and other investment accounts and savings. From that total, subtract your liabilities, otherwise known as debts. Common examples are credit card and vehicle debt, mortgages, and student loans.
Why should we care about your balance sheet? It tells you in combination with your annual spending how close you are to achieving financial freedom. This is when you are less reliant on your work income as your assets generate cash flow to support your standard of living.
Savings. The first source of building wealth is perhaps the most obvious. It’s the savings that go into your 401(k) or other work retirement plan, plus additional funds going into checking, IRAs, and other investment accounts. Savings are doubly virtuous as if you’re saving a healthy portion of your income, by definition you lower your spending. This decreases the threshold for financial freedom as you learn to get by on less. In my experience, achievement in this category for most is the largest contributor to your financial well being.
Reducing debt. If you have a mortgage, you’re reducing debt every month as you pay down principal. You’ll notice from your statement if you have fifteen years or less remaining on your mortgage that a significant portion of your monthly payment goes toward principal. Paying off student and auto loans also count as does reducing persistent credit card debt. You should also track the principal paid down on rental real estate loans as well as business loans.
Investment earnings. This is the category where we sometimes see people wanting miracles. You should absolutely expect that your investments go up in value over time. But less common that this category that makes or breaks a person’s financial success. Investment earnings include retirement plans and brokerage accounts as well as rental real estate and private businesses. If you’re invested appropriately, you can’t expect these funds to go up in value every year. But over longer periods, say five years, investments should appreciate in almost every case.
Home appreciation. Many in Boulder County are smitten with this source of building wealth. Admittedly, local real estate has gone up in value significantly since the last recession. For many local homeowners, home equity due to appreciation is the largest component of their net worth. Yet it’s a tricky one, as home appreciation may not continue at the same pace and unless you plan to downsize or move to a less costly area, having a more expensive home may not help your financial strength in the long term.
As an example of a personal balance sheet, let’s assume you have $200,000 in investments, live in a $400,000 home with a $300,000 mortgage, pay down $10,000 in principal and save $20,000 annually in retirement plans through employer and your contributions. If we conservatively expect 5 percent investment returns and 2 percent home appreciation, your financial balance sheet would be $48,000 to the good in a single year, or 16 percent of your net worth! By focusing on all four sources of financial health, you’re emphasizing what positive habits within your control (debt and savings) rather than asset appreciation, which can be fickle.