I came to this country owing more than I owned.
In personal finance terms, I had a negative net worth. Negative $4000 to be precise.
But in reality, my finances were even more fragile than that sad number. That’s because part of my nominal net worth was tied up in a used car for which I’d paid $8000. If an emergency came up and I needed money, I’d be hard-pressed to sell my car immediately, and even if I managed it, I’d probably have had to lower its price significantly.
How do you capture that fragility, or in a better situation, the relative stability?
Enter “liquid net worth.”
Defining Liquid Net Worth
Before we can define liquid net worth, we need to understand the more generic net worth.
It’s easy enough. As I alluded to above, net worth is simply the difference between what you own and what you owe.
The “own” part includes any asset worth money. This may include the following.
- Money in your checking and savings accounts
- Stocks, bonds, mutual funds, ETFs, etc. held in taxable accounts
- Stocks, bonds, mutual funds, ETFs, etc. held in tax-deferred accounts
- Stocks, bonds, mutual funds, ETFs, etc. held in Roth accounts (Roth IRAs or Roth 401(k)s)
- Cash value of any life insurance policies
- Your house
- Investment properties (if any)
- Your car(s)
- Any collectibles you may own
- The valuation of your business(es), assuming you can sell them
The “owe” part includes liabilities you’ve taken on, including balances owed on the following.
- Credit cards
- Home equity loans
- Home equity lines of credit (HELOCs)
- Student loan(s)
- Signature loan(s)
- That loan you took from your dad
- Business loan(s)
The problem with many of the “own” items is that if you had to come up with money in a hurry, they wouldn’t be available. This because they’d take time to sell and/or because selling them would cost money (e.g., realtor commissions for selling a home, taxes on capital gains, penalties for early withdrawals from tax-deferred accounts, etc.), and/or because selling in a hurry would require you to lower your asking price (remember that car I mentioned above?).
That’s why they invented the term “liquid net worth.”
The easy definition for that is the difference between what you could quickly get for your assets and what you owe.
For your most liquid assets, such as cash and balances in your checking and savings accounts, the quickly accessible value and the full value are the same. Other asset types have to be discounted, at least partially, as we’ll see below.
But first, why should you even care about what might seem like such a nit-picking difference?
Why You Should Care About Your Liquid Net Worth
The plain-vanilla net worth number is useful mostly in tracking your financial progress through life – if it goes up, you’re doing well. If it goes down, not so much.
Liquid net worth, however, tells you two crucial things.
- What’s the largest expense I could cover in the short term (including e.g. for an opportunity)?
- If my financial sky started falling, what’s the worst-case scenario I could still survive?
What’s the difference between those two?
For the latter question, you must assume that everything’s fair game. It’s your own hellish fire sale. You empty all your financial accounts including retirement ones, sell your house and cars, surrender your permanent life insurance policy… well, you get the idea.
This is what you might be forced to do if it’s the only way to save your kid’s life for example.
For the former question, assume a less dire situation. Perhaps you decide to start a new business, and you need to come up with more capital than anyone will lend you. In this scenario, you might not sell your house and cars (after all, you still need a place to live and a way to get around), but you do empty out all your financial assets.
In short, your liquid net worth tells you what’s the most you could invest if a rare opportunity showed up, and what’s the worst financial storm you could survive.
Pretty important things to know, right?
How to Calculate Your Liquid Net Worth
As we saw above, depending on which of the two questions you’re asking, your calculation would be slightly different.
Let’s start with the “fire sale from hell” situation, and put an asterisk next to those items you’d exclude from the “incredible opportunity” scenario.
For each asset type, estimate any taxes, penalties, commissions, etc. you’d have to pay to access their value, and use those to define a discount factor. Then, use that discount factor to come up with the liquid value of the asset. The following table shows you how.
For your taxable investments, I’ve assumed 30% of the balance is subject to a 25% income tax (federal capital gains tax plus state and local income taxes).
For your tax-deferred account I assumed a 10% early-withdrawal penalty on the full portfolio value, plus 40% total income tax owed on 50% of that portfolio value.
For your Roth accounts, I assumed a 10% penalty plus 40% total income tax on earnings, and that those earnings are 40% of the account value.
For the surrender value of your permanent life insurance policy, I assumed the cash value is 10% of the death benefit, and that surrender fees will consume 35% of the remaining amount. Note that this is an ad-hoc example, and your own case may be very different.
For your house, I assumes you’d have to lower the price by 10% from its market value to sell quickly, and another 10% in commissions, taxes, and fees.
For your cars, I assumed you’d go to a dealer such as CarMax to sell quickly. Using Edmunds.com’s free appraisal tool, I found that my car would get 33% less as trade-in, and 38% less as a standalone sale to a dealer.
Next, let’s calculate the liabilities. Here, there’s no discounting, because unless you plan to declare bankruptcy (in which case selling your assets would be far more difficult), your creditors don’t care about any opportunity or emergency you’re facing. They expect to be paid back in full, with interest.
Note that here I use “payoff balance owed,” which for a mortgage is higher than just the current balance. This because the current balance usually won’t show interest accrued since your last payment, or any fees you might owe for early payoff.
In this example, your worst financially survivable “all hell broke loose” emergency is the difference between your $591,200 liquid value of assets and the $265,000 owed, for a liquid net worth of $326,200.
As for the “amazing opportunity” scenario, the absolute best you could do would exclude those asterisked items, reducing your liquid value of assets to $305,000 and your liabilities to $15,000, for a liquid net worth of $290,000.
How My Calculation Is Different than Some Others and Why
Some people exclude your house value and include your mortgage balance in the liquid net worth calculation. In my opinion that doesn’t hold water. The only way you’d have to come up with the full balance of the mortgage is if you’d sell the house. In that case, as long as you properly discount the value of the house, you can include that discounted value.
The Bottom Line
While your net worth is an important measure, and lets you track your financial progress (up or down), your liquid net worth is a far more useful gauge of what you can survive and what opportunities you might be able to afford getting into. The above shows you a simple way to define and calculate that liquid net worth, whether for the survival situation or the opportunity one.
This article is intended for informational purposes only, and should not be considered financial or legal advice. You should consult a relevant professional before making any major decisions.