What is the relationship between your income and your Net Worth? Does paying down a mortgage increase your Net Worth … these are the comments made by Diane to a reader who said that they had income that was going into CD’s, but still had a mortgage:
[If] you are paying down your mortgage some – rather than just interest … then your net worth may be going up [?]
I told Diane that it doesn’t work that way Where Diane is right that putting money into CD’s while you hold a mortgage is probably a sub-optimal financial decision, it’s NOT because your Net Worth would change … paying down your mortgage does NOT change your Net Worth – it just reduces both your CASH (on hand) and MORTGAGE balance columns in your NWiQ profile …
… your total of Assets – Liabilities (hence, your Net Worth) remains the same!
Diane took me to task:
I assume [that you would be] applying income to [your] net worth and that is NOT reflected in the assets/debt columns of the networth calculations – it’s future cash for the most part (those who have incomes ;)) — or did I miss how else the income is reflected other than as a header above (along with our education)???
These are very good ‘technical’ questions, that I can explain (for those who are business/finance minded) as follows:
Income/expenses is/are a bit like a business’ P&L (Profit and Loss Statement), and your Net Worth is like a Balance Sheet … the former is a ‘work in progress’ and the latter is a ‘snapshot’ at a specific point in time.
Both cash and loans sit on the Balance Sheet … or, in our case, on our statement of Net Worth. Simply moving amounts around does not change either. Your Balance Sheet only changes if you make or lose money, grow or reduce assets (as long as you are not turning them into cash or some other balance sheet item).
Similarly for your Net Worth: decreasing a positive bank balance (on one side of your Net Worth statement) in order to similarly decrease a negative house balance (a.k.a. a mortgage) on the other side hasn’t changed anything – except where you keep various components of your Net Worth.
On the other hand, earning more profits (reflected in a businesses P&L) is similar to earning a salary or other income for a person (income) provided that you don’t spend it all (expenses) …
… they all help to increase your Net Worth (or improve the value of the business, as reflected in an improved Balance Sheet).
BUT, it doesn’t matter if you ‘store’ that extra income in a bank account (i.e. the CASH column of your NWiQ profile) or in your mortgage (effectively reducing it) … your Net Worth goes up by the amount of income that you saved since you last calculated your Net Worth.
As Scott says:
As long as you are living in your home, it is a liability and costing you money if anything.
That is, unless you are prepared to tap into that home’s equity and use that money to invest.
Yes, it’s what you ’save’ from your income (i.e. after expenses) that goes into improving your Net Worth regardless of whether you use it to build up your bank balace, pay down debt, or – as Scott suggests – buy a new asset.