We hope you had a Merry Christmas! Please enjoy this guest post by our blogging friend Jon from Penny Thots.
When it comes to improving your finances, you can do so by using some tried and true math formulas. Now, before you go and run away because you saw the word math or formula understand that I am talking about basic math here. Just simple addition and subtraction and maybe some multiplying thrown in for good measure as well. So don’t worry, there is no calculus here.
Now you may be wondering why these formulas are important in terms of our personal finances. The answer is simple: they help to put things into perspective for us. Many times we struggle with seeing how small amounts of money impact our lives over the long-term. By using these formulas, you will get a better sense of your money and as a result, become better at managing it.
So what are these math formulas? Read on to find out.
5 Math Formulas To Improve Your Finances
#1. Net Worth
The first math formula for improving your finances is figuring out your net worth. This will tell you how well you are doing financially. Basically, you take all of your assets and subtract away your liabilities. The resulting number is your net worth.
Your net worth number shows you your financial health at a moment in time. If the number is negative, this means you have a decent amount of debt and could be a sign you are living beyond your means. As your finances improve, your net worth number will increase higher and higher. By having your net worth increase over time, it shows you that you are living below your means. You are saving and investing for your future and one day, you should be able to reach financial freedom.
You should calculate your net worth at least once per year, but there is nothing wrong if you want to calculate it more frequently. I would just caution you to not calculate it too often. This can have a negative effect on your psyche and could result in you not taking the time to perform the math.
Just so you can fully understand how to calculate your net worth, here is a quick example. Assets are made up of the cash you have in your wallet and in your bank accounts. Assets also include your investments, both for retirement and non-retirement as well as your personal belongings.
Your belongings need to be valued at their market value, so you are going to have to estimate their value. Add all of these up to get your total assets.
Your liabilities include all your debts, so credit card debt, car loans, student loans, mortgage, etc. Total these up to get your liabilities. Then, take your assets, minus your liabilities to get your net worth.
Two last points on net worth.
First, some people exclude personal belongings in their net worth statement. This is because these assets really arenâ€™t growing in value. Instead they decrease in value over time. For example, your flat screen TV is worth less now than when you bought it. You are free to include or exclude personal belongings in your net worth statement.
Second, when adding in your car or house, make sure the total value (what it is worth) is placed in the asset section and the loan or mortgage amount is in the liability section so you get a true and accurate number here.
#2. Income To Net Worth Ratio
Now that you know how to calculate your net worth, it is time to look at your income to net worth ratio. You will perform this calculation once a year, after you get your taxes completed. Look on your tax return at line 7. This is the income you earned from your job for the year.
Take this number and divide it by your net worth on December 31st. The goal here is for the percent to grow to larger numbers each year. It shows you that you are saving your money and paying off debt. The larger your net worth grows compared to your income, the closer you get to not being tied down to a job. In other words, you could start living off your investments.
For example, let’s say you earned $50,000 and have a net worth of $200,000. Your ratio is 25%. Next year try to increase this ratio.
#3. Investment Income To Earned Income Ratio
While the above ratio is great, some people want to try to live off of their investment income and not touch their investments at all. We can track this as well. Just pull out your tax return again and take your earned income from line 7 and your investment income from lines 8a, 8b, 9a and 9b. Then divide your earned income by your investment income.
If you earned $50,000 and had $5,000 of investment income, your ratio is at 10%. Again, make it a goal to try to increase this number each year. The more you can increase it, the more likely you will be able to live off of interest income and quit your job.
#4. The Rule of 72
The rule of 72 is a quick calculation aimed at helping you to see how long it will take for your money to double. The math is basic here as you take the interest rate you are earning and divide it by 72. Here are a few examples:
2%: 36 years (72/2)
3%: 24 years (72/2)
5%: 14 years (72/2)
8%: 9 years (72/2)
20%: 4 years (72/2)
33%: 2 years (72/2)
What is this telling us? It shows that the amount of money you have will double in value in a certain amount of time, given a certain interest rate. Now, before you get excited dreaming about doubling your $50,000 in 2 years by earning 33%, know that you likely won’t find that kind of return without first assuming a ton of risk. In most cases, you can earn around 8% annually over the long term by investing in a diversified portfolio.
So if you invest for the long term there, you can expect your money to double roughly every 9 years. The power of this formula helps you see how much you can grow your money over time and will help you increase your net worth in time as well.
#5. Compound Interest
The power of compound interest is incredible. Over time, your money grows faster and faster because not only do you earn interest on your balance, but you also earn interest on your interest! Sound too good to be true? It’s not.
Take this example for instance. Let’s say you save $5,000 and can earn 5% interest on your money. In one year, you earned a not-so-incredible $250 in interest. In year two, you earned a little more, $512.50 but nothing that will allow you to quit your job. But fast forward 25 years and look what happens.
In 25 years you are earning almost $12,000 in interest each year. For doing nothing! If you save more than $5,000 then you will be earning more interest faster. If that doesn’t excite you, I don’t know what will.
Now, I will be the first to tell you that the formula for calculating compound interest is a little more involved than the two previous formulas. But luckily, there are financial calculators online for you to use. Simply plug in a few numbers and in no time you have your answer.
But for those math lovers out there that want to do the math themselves, here is the formula:
See, I told you it was little more involved. Again, donâ€™t fear as you can easily use a calculator to help you out with this one. And trust me, you want to play around with this one for a bit just to see how powerful compound interest it. While the interest you earn might seem small at the start, it really adds up over time.
In the end, knowing a few basic personal finance equations can jumpstart your financial life and help you to achieve your financial goals. The math is basic so you have no excuse there, and as I mentioned, there are even calculators online for you so you have two reasons why you should be figuring out these numbers starting today. They will only take you a few minutes to calculate but the answers they give you will help set you up for great financial success down the road.
Jon writes at Penny Thots, a personal finance blog that talks about all things personal finance. The goal of the site is to improve your finances one day and one penny at a time.