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How Debt Impacts Your Net Worth

Debt has been getting a bad rap lately. It seems that if you have a radio show and you talk finance, you think all debt is bad. No wonder many consumers think that all debt can only have a negative impact on their net worth. But this isn’t necessarily the case.

Net worth, or simply wealth, is calculated by adding up all of your assets and subtracting all of your liabilities (use Mint’s interactive tool to get a quick estimate of your own net worth).

Let’s take a look how a simple loan situation might impact net worth. Imagine that you have no assets and no liabilities. You go down to the bank, take out a $10,000 loan and deposit the money into your checking account.  What was the impact on your net worth?  None… really, there was no impact. You now have $10,000 in the bank and $10,000 in liabilities. Your net worth is zero. You probably feel a little richer because you have money in the bank, but you also feel a little poorer because you have a loan to pay back. But the net effect is zero, at least for now.

How debt can enhance your net worth

If that loan has a high interest rate and you leave the money in your checking account earning no interest, your net worth will soon fall below zero. If, on the other hand, you invest the money in a way that earns you more than the interest you pay on that loan — then your net worth will be positive.

The positive or negative effect of debt on net worth almost always occurs sometime after the loan is taken out.  The cost of the loan impacts net worth. How the loan proceeds are spent impacts net worth.

If you used the $10,000 to eat out at your favorite restaurant three extra times a month, the impact on your net worth would be negative. If you buy a reliable used car that helps you get to a job that pays $10,000 more per year than you currently earn, the impact on your net worth is going to positive. The key is that you evaluate how any new debt will impact your net worth over time before you take out the loan.

Not all debt is negative

You can’t just say that all debt is bad. The important thing is to use debt prudently and to evaluate the benefit of the loan from a net worth standpoint.

Don’t blame debt.  It’s not debt that is bad. It is how you use it that matters.

Here are some tips on managing your debt so that it doesn’t end up hurting your net worth.

  • -When financing, investments are the only thing that can have a positive impact on net worth
  • -Never finance any item that is consumed immediately (e.g. dinner, vacations, etc.)
  • -Durable consumer purchases (e.g. TVs, cars, iPads, etc.) can never improve your net worth because they depreciate
  • -Always factor finance costs into the cost of a financed consumer purchase
  • -Debt used to finance consumer purchase should be repaid before the you stop enjoying the  benefit.

 

How Debt Impacts Your Net Worth Was Provided by CreditSesame.com.