Liquid Net Worth: Your key to staying out of debt

by Rob Bertman, CFA®, CFP® in Debt, Wealth building
September 10, 2020
liquid net worth

Liquid Net Worth: Your key to staying out of debt

Maybe you’ve heard about net worth before, but what the heck is this liquid net worth thing and why does it matter?

The term “liquid net worth” may be new to you, but it’s something that you should take a serious look at if you want to avoid getting in debt.

I’ll show you the traditional way to calculate it.

Then I’ll show you the more impactful yet simpler calculation I use with my clients to help them get out of debt and and stay out.

Net worth vs liquid net worth

Total net worth is something you might be familiar with. It’s how much you have left over if you subtract the value of what you own (assets) from everything you owe (liabilities aka debt). 

That’s net worth aka wealth.

The best way to calculate it is to create your personal balance sheet, a list of all of your assets and liabilities. Once you have that together, calculating your net worth is easy:

Net Worth = Assets – Liabilities

Liquid net worth is close to that, but it’s a little bit different. 

What happens if you had to sell or liquidate everything you own in a jiffy? 

You’d probably have to sell things for less than their worth to get cash quickly in hand.

This could include taking a haircut vs the actual value of your house, paying an early withdrawal penalty on your retirement accounts, and discounting the sale price of your cars to make it happen quickly.

Liquid assets, like cash, don’t need to be discounted. You can just use it. But any asset that is hard to sell and would need to be converted to cash quickly would most likely be sold for less than its actual value.

Liquid net worth is the stress test of what would happen if you took the fire sale values of your assets to pay off all of your debt. 

Therefore liquid net worth is lower than your actual net worth.

Liquid Net Worth = Discounted Assets – Liabilities

What is liquid net worth and how do you calculate it?

In order to calculate liquid net worth, all of the debt stays the same. Credit card debt, mortgage, car loans, student loans, and any other debt all keep the same value.

The main change from net worth to liquid net worth is what would happen if our assets are turned into cash quickly, converting any hard-to-sell or illiquid assets to liquid assets.

Let’s take your house or condo for example.

Real estate – Liquid Net Worth Calculation

You can try to figure out the value of your house by checking Zillow or looking at the other real estate comps in your neighborhood to see the recent transactions. 

But these sales are most likely under normal conditions. Plus, they don’t take into account the real estate agent fees of 5-6%.

So if you had to sell your house quickly (in a “normal” housing market), the list price would probably have to be the real value discounted by about 20% for a fast sale. Then you’d have to pay your realtor 5-6% of the sale price.

If your house is worth $400,000 according to Zillow, then here’s what you could end up with if your house is priced to sell quickly:

liquid net worth home

That’s nearly a 25% haircut from its current value! If there’s a $300,000 mortgage on this property, the home equity on your personal balance sheet just went from $100,000 to $800.

home equity

In the real world, this could happen. If a family already bought another house but their old one hasn’t sold yet, they can only carry two mortgages for so long.  At some point, discounting the listing price significantly becomes a very serious option.

Let’s continue with another major category, retirement assets:

Retirement Accounts – Liquid Net Worth Calculation

You may see your current balance on your traditional (pre-tax) retirement plans whether it’s a 401(k), 403(b), 457, or traditional or rollover IRA. But if you wanted to access that money, it’s not actually what you would get out.

Let say you have $200,000 spread between all of your pre-tax retirement accounts and you’re in your 30s or 40s. 

Well, first of all, there’s a 10% early withdrawal penalty. Then, the distributions are subject to your marginal income tax rate (both federal and state).

Pretend you’re in the 24% marginal federal tax rate and your state taxes are 6%. That $200,000 on your balance sheet is actually worth a heck of a lot less if you wanted to use it today:

early retirement plan distribution

People actually do this!  They take early distributions from their pre-tax retirement accounts, taking a 40% haircut to do it. That hurts!

My goal is to help you avoid this which is why I’ll share my version of liquid net worth and why it’s so important further down.

Roth IRA early distributions work a little differently because the contributions are made post-tax. Any money contributed can be taken out without taxes, and there’s the five-year rule for taking out the earnings portion.

Vehicles – Liquid Net Worth Calculation

This is a relatively simple calculation.

Look up the Kelly Blue Book value. Decrease the condition of your car to the next level down, then subtract 20% from that value.

So if KBB says the car is worth $20,000, take $4,000 off the value to convert it.

(There are other liquid net worth calculations to consider, but they don’t apply to most people so let’s move on to the example.)

Liquid Net Worth vs Net Worth Example

Let’s look at how the liquid net worth calculation vs the normal net worth calculations differ continuing on with the above example.

This hypothetical couple has: 

  • $200,000 in pre-tax retirement accounts 
  • $400,000 home with a $300,000 mortgage
  • A minivan and an SUV currently worth $20,000 each. $20,000 in combined auto loans.
  • $30,000 in student debt
  • $15,000 in credit card debt
  • $20,000 in checking/savings

Let’s see how the calculations are different:

Take a look at the asset values side-by-side.

Net worth vs liquid net worth

The liquid net worth calculation reduces their assets by $187,200.

Here’s the debt side of liquid net worth which is unaffected by the calculation (aka no discounts):

liquid net worth debt

Liquid net worth will be lower than net worth only because of the discounted asset values:

calculate liquid net worth

Now you know how to calculate liquid net worth.

Exciting right? Ok, maybe that’s a stretch. 

I’ll admit it’s not the most fun thing to look at, because you may already feel behind financially. This makes it look even worse.

But this is a worthwhile exercise for sure, because it will make you think twice (and hopefully stop you) before tapping into very costly ways to get your hands on more cash.

I make these discounts on our personal balance sheet, because it’s a great way to stress test our financial situation.

The Problem with Liquid Net Worth

Let’s be honest, liquid net worth doesn’t really help you in your day-to-day life.

It’s also a little complicated to put together and can be depressing to look at.

What if you want to avoid extreme measures like selling your house, your car, taking money out of your retirement assets, or taking out toxic forms of debt? 

Wouldn’t you rather be in a position to be prepared without having to uproot your life? 

This is the problem with looking at regular net worth or liquid net worth.

It’s a calculation for the most dire of life circumstances. Worse yet, it provides the illusion that we’ll be ok because we have things we can do as a last resort.

I’ve seen far too many examples of people who have resorted to some of these extreme measures, sabotaging their future financial freedom because of a net worth imbalance or lack of it in the most important area.

Yes, net worth it is important to know, but let’s talk about something more tangible that will help you stay out of debt and weather the unexpected storms that may come your way.

It’s a much simpler idea that will give you the right info to make positive changes in your financial situation. 

The side benefit is that you will finally be able to articulate why money is a major source of financial stress for you so that you can change it.

Here’s how to do it.

Family Budget Expert’s Liquid Net Worth Calculation

You’ve probably heard the term “house poor”. It’s when someone has too much money tied up in their house so they struggle to make ends meet day-to-day.

Well, there’s also the concept I call “retirement plan poor” where money is trapped in something you can touch without a major cost until you’re 60.

I’ve worked with many families that have a decent amount of home equity and retirement funds, yet they still live paycheck-to-paycheck with minimal cash and credit card debt.

So when I think of liquid net worth, I think, “What money could we use today without any major costs or uprooting our life?”

The answer lies in what I call “free & clear” funds. This is money you can access quickly at any time and for any purpose, my version of liquid net worth.  

This may sound a little like an emergency fund. Yes, that is included in the calculation, but it takes it one step further by adding some other assets and netting out some debt. 

It’s a little closer to the corporate finance equation for working capital but much simpler.

Free & Clear Funds = Checking/Savings +  Brokerage Investment – Credit Card Debt – Personal Loans

Remember from the prior example, that they had a net worth of $295,000 and a liquid net worth of $107,800?

How much do they actually have free & clear though?

net savings

Only 1.7% of their net worth is free & clear. Now that causes day-to-day financial stress.

Lose a job? Have an unexpected home repair? Car breaks down? They are in a serious predicament, because the rest of their net worth is tied up.

The only choices available? Take out more debt or take a big hit by selling assets at fire sale prices. Neither is a good option and can be prevented.

What else does this tell us? 

It tells us that although someone may feel good about having $20,000 in the bank, it’s actually not a true measure of their ability to make it through an adverse financial event. It also has negative effects on well-being.

I’ve seen many people think they have a solid amount in cash, but they have a mound of credit card debt next to it. This leads to:

  • Anxiety every time the credit card bill comes
  • Needlessly spending thousands on credit card interest
  • The illusion of financial security

I totally understand it can be hard to part with cash and may feel easier in the moment to carry a credit card balance. Cash equals security for many of us, and credit cards are “funny money”.

Building your free & clear funds can be life changing and the decision-making is much simpler. 

Save more money and pay off credit card debt.

Do this on your own. Take your bank account balances and subtract your credit card debt. 

Feel that rush of anxiety or stress just thinking about it?

Step 1 on your journey to eliminating financial stress and growing toward financial freedom is growing your free & clear funds.

How to Grow Your Free & Clear Funds

You might think I’m about to recommend some drastic measures here, but I’m not.

Taking major action can get you from A to B quickly, but I’m a firm believer that people don’t take drastic measures unless they have a drastic life event. 

Most of us need to take a more gradual approach, because the most important thing is progress toward the goal that will stick. 

You don’t have to turn off your retirement plan contributions or take all of your cash to pay off your credit card debt (unless you are 100% committed to doing it – together as a couple). 

What you do need is to focus your attention on getting out of credit card debt and building your savings faster than you already are.

I would suggest in this instance to take $5,000 from their savings account to pay down some of the credit card debt.

pay off credit card debt

Boom, you just saved about $1,000 in interest and probably freed up a couple hundred bucks in monthly payments.

Notice that this doesn’t change the free & clear amount, but it does jump start the process without feeling like it’s a huge sacrifice.

To actually increase free & clear funds, it means throwing any extra money at the end of the month at the credit card debt ONLY.

Got a second job, a raise, bonus, or tax refund? Throw the additional money at it.  

Are you able to cut your spending a little bit? Put it all towards the credit card debt.

If you want to spend some of the extra money that comes in, that’s fine too. Just use my 50/50 Rule so you don’t go overboard.

The most important thing is making this your primary focus and taking the smallest sustainable step to make progress.

The biggest relief I’ve seen from my clients is becoming credit card debt free and having a solid savings account.

Need some help getting there?

Many think personal finance is all about doing everything at the same time and only taking steps that optimize and maximize the growth of your net worth.

I used to think that too.

But as I learned in the book The ONE Thing, it requires focus on the one thing you can do that will make everything else easier or unnecessary. 

What is the “lead domino” as they call it? It’s a focus on spending.

That’s where the money comes from to advance your financial goals.

How great will it be when you have $0 credit card debt and a solid amount of cash? How much more in control will you feel over your financial situation?

It is possible. How do I know? This is my sole focus and clients have gotten these results.

I’m here to help you get there.

Not ready to talk but want some help?

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