There are 3 tools that folks can use to manage their personal finances. They are a personal life plan, a personal budget and a personal balance sheet. When these tools are identified to folks most acknowledge a life plan but do not really have one. Most know and try to have a budget…sort of. However, an amazing number of people have no idea what a balance sheet is. So here are the basic things you should know about a balance sheet.
Why should I have a balance sheet?
A balance sheet is where you keep track of how much you own and how much you owe and the difference between the two. You take the value of your assets (what you own) and subtract the value of your debts (what you owe) to get your net worth. You should know what your net worth is at any given time. It is also important to know the value and structure of your assets and liabilities.
Your net worth should be a positive number. The older you are the bigger the number should be. That is because you will need this net worth to finance your retirement when you can no longer work to provide income to your budget. The assets in your balance sheet fund your retirement in three ways. They keep costs down. The best example of this is home ownership. If you own your own home you will not have to pay a mortgage payment. That means you need 30% less to live on each month. The second way that assets fund your retirement is that you invest them in income producing assets such as Certificates of Deposit, Bonds or dividend producing stocks. A third way is that you can sell off assets at a gradual pace to fund your budgetary needs as you age. A reverse mortgage is a good example of this.
Assets and Liabilities
You need to know what an asset is and what a liability is. You also need to know that there are different kinds of assets and different kinds of liabilities.
An asset is an item of value that you own. It has a market value that is the amount that you can sell it for. The value is what the item would sell for if you had to sell it in the short term which may be days or months depending on the asset. When valuing your assets you must consider this and be honest about exactly how much your asset would sell for in the short term. The total value is written down as the asset on your balance sheet. There may be an offsetting liability. For a house it would be the mortgage or any other debt secured against the home. For a car it would be a car loan. The difference between the value of the house or car and what is owed is the equity in that particular investment. This is like a net worth for that particular asset.
There are appreciating assets and depreciating assets. A home is generally an appreciating asset over the long term. In recent times we have learned that in the short term a home can lose its value rather quickly. However, most housing markets recover in the long term and a home should appreciate over time. A car is almost always a depreciating asset. That means that as it ages it becomes worth less each year. Appreciating assets are more balance sheet friendly than depreciating assets.
Assets that can have a lien put on there are the only ones that banks or other lending institutions will consider as valid as asset entries on a balance sheet. Things like furnishings and jewelry are not considered assets for use in getting a secured loan. Items such as the unused part of a line of credit or credit card limit are not assets on any form of balance sheet.
Liabilities are what you owe. Any form of debt is a liability. There are many forms of debt. There is secured debt. That means that the debt is secured by a lien against an asset that you own. The lien and the debt should be for less than the resale value of the asset. Unsecured debt does not have any such lien and is hopefully based on your capacity to service the debt. The problem with unsecured debt like credit cards is that it is not offset by some asset that you own and acts only to reduce the net worth on your balance sheet.
Credit card debt would thus be categorized as bad debt as it only acts as a drag on building positive net worth. A mortgage where you pay the principal down a little each month as the property is increasing in value is good debt. That is because you add to your net worth in two ways; first you pay off the debt and the second way is that the asset that secures the mortgage (your home) increases in value while you pay off the mortgage. Both deliver increased value to your net worth.
Balance sheet goals
There is only one goal that you need to focus on for your balance sheet. You need to own more than you owe. The normal pattern is that the older you get the larger your net worth becomes. There are two basic dynamics that contribute to this trend. One is the miracle of compound interest. The longer that assets are allowed to compound in savings and investment products, the larger the annual contribution is to your personal net worth. This is particularly true for the second basic dynamic. The largest portion of most people’s net worth is the ownership of their home. As you pay down your mortgage, the later payments pay a higher percentage against the principal and less on interest. It is a form of reverse compounding. You pay less interest. In addition the compounded increases of property values are very high when you put them in perspective of what you may have paid for your home 20 or 30 years earlier. Some years they may go up as much as you paid for the house when you bought it.
For the average person this article is a good start on what you need to know about a personal balance sheet. As you work with your personal balance sheet you will learn more and more about financial products and how to use them to increase your net worth. Your net worth is the ultimate bottom line. If a financial product does not deliver positive results to your net worth then you should look for another product