Most people believe that income = wealth. Many people think that the bigger paycheck, the richer you are. When it comes to finances, there are a few myths that we must start to dissect. Because the truth is, income does not equal wealth.
Wealth is defined by a person’s net worth, which we will discuss in detail later on in this article. Net worth is the true indicator of wealth, and it doesn’t just involve income.
This article will debunk this big financial myth, so you can be more aware of your true wealth, and how you can make necessary changes in your personal finance.
What is income?
The IRS defines income as earned income that is taxable. In short, income is the money that you receive from different sources. This stream of money is mostly used for your expenses and helps you in the creation of wealth. Income is not used to indicate wealth or your net worth.
Here are some examples of income streams:
- Rental income
- Wages and salary
- Interest on savings and securities
- Dividends from investments
- Income from a business
While income is not the sole indicator of wealth, it can be considered your biggest wealth-building tool. as you can use your paycheck to create your wealth.
If you’re wondering why income is not the sole indicator of wealth, here is an illustration:
Jessica earns $32,000.00, while Donna earns $50,000. Given these figures, it’s easy to say that Donna is wealthier than Jessica. Well, that answer depends on a few things.
Let’s say Jessica does earn $32,000 but spends $20,000, leaving the rest of her $12,000 saved in a bank. Donna earns $50,000 but spends $49,000, leaving her with only $1,000 in the bank.
At the end of the year, Jessica has $12,000 in a bank, while Donna only has $1000. In this illustration, it can be seen that Jessica is wealthier then Donna, even though the latter has a bigger income.
Wealth is not measured by how much you earn, but how much you keep. Therefore, although a bigger income can be leveraged to make you wealthier, at the end of the day, the money you keep is more important than the amount you earn.
What is net worth?
Net worth is the true indicator of wealth and it’s calculated by adding the value of everything that you own minus the value of everything that you owe. In other words, personal wealth is measured by your net worth and not your income.
The correct financial term for things that you own is assets, while the term used for everything that you owe is called liabilities. Therefore, your net worth is assets minus liabilities.
Net worth can be both positive and negative. It is positive when your assets outweigh your liabilities, and negative when your liabilities outweigh your assets.
Positive net worth
For example, the total value of your assets is $500,000, and the total of your liabilities is $450,000. Your net worth is $50,000. Because your assets outweigh your liabilities, you have a positive net worth of $50,000. Therefore, you have a wealth of $50,000. You can use this amount to further build your wealth, such as investing in stocks, creating a new source of income, and other assets.
Negative net worth
If you have a total asset of $500,000 and your liabilities is at $600,000, you have a negative net worth of $100,000. Since your liabilities outweigh your assets, then you don’t have wealth and have a debt of $100,000. When you have a negative net worth, it means you have to reduce your liabilities and increase your assets in order to build wealth.
The key differences between income and net worth
Here is a summary of the main differences between income and net worth:
- Income is a steady stream of money while net worth is assets minus liabilities.
- Income does not equal wealth, but net worth does.
- Income is earned while net worth is built.
What are assets & liabilities?
Now that you know how to compute your net worth or your wealth, it’s time you know the things that are considered to be an asset and the things that are considered to be liabilities.
Assets are key to building your net worth. These are resources owned or controlled by you. This is anything of value that you can convert to cash. Here are some examples of assets:
- Investments in stocks, bonds, mutual funds
- Real estate that you can sell or lease
- Savings accounts
- Valuable items such as jewelry or antiques
Your home or car can be considered an asset if they’ve already been paid for. If you still pay a mortgage or monthly car payments, they are not considered an asset but a liability. Any item that you have that can be resold or converted to cash within 1 year is an asset.
It is important to note that furniture, personal belongings such as laptops, furniture, and electronic devices can be considered as assets but since they depreciate over time [the minute you buy them], their value depends on depreciation, otherwise known as the loss of earning power. The possibility for resale of such items is not guaranteed, and therefore, will not be included in your list of personal assets.
Moreover, while an educational degree does have value and provides you with a future stream of income, it should not be included in your list of personal financial assets, because it cannot be resold, nor converted to cash.
Assets that can be readily converted to cash are what you can include when you compute for your personal net worth.
Now let’s proceed to liabilities. Liabilities are any amount that you need to pay. Anything that takes money from you is a liability,. Some examples of liabilities include:
- Car payments
- Mortgage Payments
- Credit Card Payments
- Student Loans
Using these examples, let’s now create a detailed computation for a person’s net worth:
Savings – $10,000
Emergency Fund – $5,000
Income from Rental property – $1,000
Total = $16,000
Student Loan – $8,000
Cay Payments – $5,000
Total = $13,000
Assets ($16,000) – Liabilities ($13,000) = $3,000.00
In this example, you have a net worth of $3,000, and therefore you have a positive net worth.
How to improve your net worth
Here are some tips for improving your net worth:
- Pay off your debts
- Stop borrowing money or buying things on installment if you can pay for them in cash.
- Set aside money form your income to invest in other income streams
- Start a side job or business to increase your income
- Collect more assets
The bottom line
Income does not equal wealth, as we’ve learned in our examples above. As mentioned earlier, income is not an indicator of wealth, but net worth is. By taking a look at your income, net worth, assets and liabilities, you are able to get a clearer picture of where you stand financially. When you realize you have a negative net worth, you can take the necessary steps to make sure you turn that negative net worth into a positive one. Once this is achieved, you can start enjoying financial freedom, and live the life that you desire.