Retiring Early With Low Net Worth

In spite of certain political talk to the contrary, it’s pretty clear to most of us now that we’ve just come out of a recession. It’s likely that more and more Americans are feeling pretty good about their finances. It’s likely that folks haven’t been richer in many years than they are today, except for maybe in 2006 during the peak of the housing bubble.

It’s likely that folks are making decent money again and that they don’t feel like every day is a struggle to stay afloat. People might even be putting away some money for retirement and seeing their paper wealth begin to grow.

Except they’re doing it all wrong.

After reading this article, you aren’t going to like me very much. It’s going to start out informative, and I’ll show you how to calculate your net worth. Some of you will feel good about yourselves after calculating that number, and others will feel pretty lousy.

But then, I’m going to make most of the folks who read this feel lousy by pointing out why almost all of your wealth might be completely useless, why your net worth has almost no impact on your ability to make day-to-day decisions, and why you are really deep in a financial mess that chains you to your job and makes you a slave to money.

In this article, you are going to see what the difference is between net worth and useful net worth. You’re going to see how most folks under 40 with a goal of not being forced to work for a salary until the age of 59 and a half are in pretty poor financial shape and are taking almost no action to improve their positions.

Worse than that, they think that they are making the right choices in life. Choices that conventional wisdom tells us are correct and responsible.

Take a deep breath, and let’s dive in.

What is Net Worth?

One’s net worth is simply the number of assets that one owns, minus the debts that one owes. Folks track net worth in a variety of ways and have a variety of theories about the best way to do this.

Here’s a common example of how a typical American might track his or her net worth:

Sam has the following assets to his name:

A Honda Accord worth $20,000

A home worth $300,000

$7,000 in cash

$200,000 in retirement savings in a 401(k)

TOTAL Assets: $527,000

Sam also has the following debts:

A car loan of $17,000 on the Honda

A mortgage for $240,000 on his home

$4,000 in credit card debts

$30,000 in student loans

TOTAL Liabilities: $291,000

Sam’s Net Worth in this scenario is $236,000.

If you were to swap the word “individual” with the word “business,” then the financial statement that shows your net worth would be the equivalent of a company’s balance sheet. In this case, Sam is worth about a quarter of a million dollars and might be feeling pretty good about himself.

So, why is this number so important?

In and of itself, the net worth number is pretty useless other than as a vanity metric. But in that sense, it is VERY important. This is the first number that folks will think of when they calculate their financial positions. It’s a number that boils down exactly how many dollars they have to their name across all of their financial positions. It’s also the number that most folks try to increase as much as possible. This is unfortunate, as it leads to decision-making that would otherwise be considered irrational if net worth were looked at in a more intelligent manner.

Personally, I don’t care about my net worth as calculated in the example above because many of the numbers used to compile it are pretty meaningless. What do I care if I have $200,000 in retirement accounts? I’m 25, and I can’t access those funds until I’m of retirement age (30+ years into the future), so they do not have any direct impact on my day-to-day decision-making — or even really my long-term decision-making.

As my goal is to retire 30+ years in advance of the normal age, I care only about those aspects of my net worth that are directly relevant to my goal—that is, my usable wealth. Usable wealth is ONLY that wealth that will impact my goal of retiring early and excludes much of Example Sam’s net worth.

Now, that said, it is certainly useful to remain up-to-date on your holistic financial position. You should (and I certainly do) keep an eye on the value of your retirement accounts, home equity, car, etc. If you aren’t paying constant attention in this game of finance, you will lose. Whether through theft, ticky-tack fees, or by making an obvious mistake, those who do not closely watch their assets and where their money is going slowly lose in the game of money.

If you don’t know your net worth at the moment and regularly check up on it, then this might be one of those tasks that you set about completing immediately at the conclusion of this article. There’s no point in playing the game of finance if you can’t even keep score.

Two Types of Net Worth

As I’ve already alluded to, as far as aspiring early retirees are concerned, all net worth is not created equal. If you plan to retire before 40 years old, then money in 401(k)s and other IRAs might as well be on the moon. You’ll get there someday, but it is not directly relevant to your goals. That’s the whole point of early retirement—to create a sustained state of passive investment income that covers your living expenses at an extremely young age and in an extremely short period of time!

Furthermore, when it comes to tracking net worth, we have to acknowledge that some of the things that most people call “assets”—like a car, for example—are in fact not relevant factors in pursuit of the goal of creating a state of financial independence. The same would be true for boats, collectibles, jewelry, electronics, etc.

The problem here is that while those kinds of assets may well be worth something, the fact that you are holding them means that you do not *intend* to sell them or use them to produce passive income to fund an early retirement. If I’m wrong about you and your personal situation and you do intend to sell these items in the near future (or expect them to increase in value), then feel free to include them in your statement of net worth!

But I’d argue that few people hold a boat or a car hoping to sell it at a gain down the line and make a profit on their boating/fishing hobby or daily commute. And if you are collecting baseball cards or art in order to build wealth, then you might want to get your personal finance advice somewhere else.

Perhaps painfully, if one has debt on a car, boat, or other item similar to those described, that debt does get included in the net worth calculation. You still have to pay the car loan, regardless of whether the car produces investment income that enables financial freedom.

This is why buying luxuries on credit is such a drag on middle class America’s finances. Financed cars, boats, trucks, TVs, computers, and the like are a double whammy, as they are not assets that serve the goal of financial freedom, and the debts must be counted against their financial position.

Following my logic, we face a conundrum. On the one hand, assets like cars, boats, jewelry, and retirement accounts do have a real value, and we would be wise to keep an eye on their value over time to aid our decision-making processes.

On the other hand, they are not relevant to our goal of financial freedom at an extremely early age.

My solution? I track BOTH types of net worth—I track my total net worth, including all of my assets/luxuries and retirement accounts in one application, and I track only that net worth relevant to my goal of financial independence in the other.

Calculating Usable Net Worth

We’ve already demonstrated how to calculate the first type of net worth above. Here’s how Sam would calculate his usable net worth under my philosophy:

Sam has the following useful assets to his name:

$7,000 in cash

TOTAL Usable Assets: $7,000

Sam also has the following debts:

A car loan of $17,000 on the Honda

A mortgage for $240,000 on his home

$4,000 in credit card debts

$30,000 in student loans

TOTAL Liabilities: $291,000

Sam’s usable net worth is NEGATIVE $284,000.

How did this happen? Well, Sam made three key mistakes that far too many middle class Americans make:

He bought a financed car.
He bought a luxury home with a huge mortgage.
He failed to build any significant wealth outside of a retirement account.

Folks, this is likely what most of America considers to be a strong financial position! This is absurd. It is also why most of America is unable to get ahead. A lifetime of “smart” decisions, and Sam is in a $284,000 financial hole. Another way of expressing this is to say that Sam has $284,000 in debts against any ability to make big life decisions that would disrupt his current income or lifestyle. This is why Sam has no choice but to continue to work his job for decades.

So What Should Sam Do?

When most people ask the question, “How can I begin investing in stocks/bonds/real estate?” or “How can I start a business?” they do so from this position right here! The hard and painful answer to that question is this:

Accept the fact that your financial choices to this point in life have resulted in a several hundred thousand dollar hole, and slowly and steadily begin to climb out of it. Otherwise, you will struggle to do anything other than maintain your current position in life.

If he’s asking me, Sam needs to get serious about building wealth and make some drastically different choices immediately. Sam is not going to like any of this advice:

First, he needs to harness the $60,000 in his home equity by selling his home and moving into either a far less expensive one with a smaller mortgage, or renting and investing the entire $60,000 in proceeds.

Second, he needs to sell his car and buy a used one with $3,000-$7,000, cash.

Third, he needs to start paying down his personal debts and get them to zero.

Fourth, he needs to start saving a much larger percentage of his income so that he can begin investing in assets outside of his retirement account. Notice that I am NOT saying that Sam should forgo investing in a retirement account. That’s a personal decision, and there are smart arguments both for and against doing so. I AM saying that wealth in a retirement account is fairly useless for those that aspire to become financially free at an early age and that if the majority of your net worth creation is going on in that account alone, that you are in big trouble.

It is at this point that Sam will be in position to spend the next several years rapidly building real wealth that gives him real options in life. No longer will he be chained to that mortgage, job, and vesting 401(k) interest. Sam will soon have tens of thousands—and not too much later, will have hundreds of thousands of dollars—in real, tangible assets like stocks and bonds, investment real estate, and a sizable cash position. In a few short years, he could buy back all of his prior luxuries with cash and the option to walk away from work entirely for months or even years.

With a long enough grind and a smart investment strategy, Sam could even retire in just a few short years, living forever off of assets that are not locked away in retirement accounts!

Of course, I’m living in fantasyland.

Sam is not going to sell his house and cramp his style. Sam is not going to sell his car and do the same. Sam is not going to cut back on his spending so that he all of the sudden starts saving thousands of dollars per month outside of his retirement account.

No, the best we can hope for with this article is to help Sam at the very least understand that most of his assets are really liabilities—or at best, are useless, given his stated financial goals of achieving financial independence.

Sam hopefully will keep that in mind over the next few years, and when he gets a raise, simply will not correspondingly increase his spending. Instead, he’ll put most of that extra money toward paying down debts. After a few more years and a few more raises, Sam will have paid off those debts and begin investing outside of his retirement account.

In 10 years, when Sam sells his home, he’ll buy a very reasonable replacement instead of the biggest, fanciest one he can qualify for. Slowly but surely, his position will improve, and one day, he will finally have a truly positive usable net worth, and maybe, just maybe, he’ll bring some options back into his life.

Conclusion

Sam! I wish I could save you those decades. I wish I could impress upon you the financial consequences of your decisions in those early years and the abundance that could be yours if you let go of your biggest “assets” and harnessed the wealth you’ve trapped in them to produce real returns elsewhere.

But, in failing to do that, I hope at least that you begin to build a little wealth outside of your home equity and retirement accounts. I hope that you focus your financial strategy around increasing that wealth from now on, instead of buying useless or even actively detrimental “assets” that do not support your goals.

And I hope that eventually, slowly but surely, you are able to buy some freedom back into your life. I hope that you buy yourself the power to decide whether and where to work—and what you do during the best part of your day, during the best part of the week, during the best years of your life.

We’re republishing this article to help out our newer readers.

Looking to set yourself up for life as early as possible and enjoy time on your terms? Scott Trench’s new book Set for Life is now available! Whether you’d like to “retire” from wage-paying work, become less dependent on your demanding nine-to-five, or simply spend time doing what you love, Set for Life will give you a plan to get there. This isn’t about saving up a nest egg. It’s not about setting aside money for a “rainy day.” Set for Life is an actionable guide that helps readers build the accessible wealth they need to achieve early financial freedom.

What are you investing in to prepare for an early retirement? Do you track your net work regularly?

Let me know what you think with a comment!

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.