In any discussion about personal finances, there are three terms that show up again and again: income, wealth and net worth. While these terms may seem interchangeable, there are a few important differences between them.
Understanding these differences is important when it comes to getting an overall sense of your financial health and creating an effective long-term plan. Read on to learn how income affects wealth, and how you can use these concepts to determine your net worth.
1. What Is Income?
Of the three concepts mentioned above, income is perhaps the one most people are familiar with. In short, income is the amount of money you receive. Usually, your income is computed per month, but there are other sources of income that can be received per week, quarter, or even year.
For most people, an income is synonymous with a paycheck that they receive on a monthly or biweekly basis. However, there are many other types of income, such as rental income if you are a landlord, income you get from selling stocks, etc. Let’s take a look at a few of the most common ones.
Salary or Hourly Wages
As mentioned above, the basic source of most people’s income is a salary if they are working for someone else. In exchange for services, the company pays a certain amount of money per year or per hour. Bonuses and other monetary benefits are also considered income.
Another source of income is commission. This type of income is common for people who work in sales. Unlike a salary, commissions are not usually paid per month, but instead, per service completed or goal reached. Commissions can be combined with a base salary. Like commissions, tips also count as income.
Profits or Net Revenue
If you have a business, then you receive an income through the net revenue you earn by selling your products. By subtracting the expenses of your business from your total income, you get the amount of your profit from the business.
Another source of income is interest from loans. If you lend your money to someone with an agreed interest, then you are earning an income through that interest.
Likewise, the interest you earn on your bank is part of your interest income, as the money you deposit to banks is considered a loan.
If you have shares in a company, then you probably know about dividend income already. This is the income generated when you have invested in a profitable company.
If you have real estate, then you can rent it out to receive a rental income. The money you earn is your taxable rental income.
1. What Is Income?
Unlike income that is generated over a certain period, wealth is the accumulation of assets a person has at any given time. Typically, anything that you can sell or liquidate (turn into cash) is part of your wealth. Let’s look at a few common sources of wealth.
Cash and Savings
Whether it is in your wallet, piggybank or lying around your house, any cash you own is considered part of your wealth. Likewise, any money you have in a savings or checking account is also counted as wealth.
The market value of all the property you own is considered part of your wealth. This value changes as the economy changes. It is also hard to pinpoint exactly how much your properties are worth unless you liquidate or sell them. But you can determine their value by comparing your properties to similar properties that are sold recently in the market.
Inheritance and Gifts
All the money that you received through an inheritance counts toward your wealth. If a family member, friend or acquaintance recently departed and gave you a part of their wealth, you can count that money or property as part of your wealth.
People who inherit a lot of wealth that has been passed down several times have what is called “generational wealth.” This is the accumulation of the wealth of one or more past generation that is passed down to the next generation.
Even items that are not money are considered toward your wealth, as long as they have monetary value. For example, an expensive diamond that you can sell in the future is part of your wealth.
While the earnings you have through dividends or through the sale of your investments are part of your income, the capital itself is part of your wealth. This might seem confusing, but think of it like an investment rental property. The property itself has a certain value that fluctuates and is counted toward your wealth. However, any rent you receive while you own that property is counted as income.
3. What Is Net Worth?
The net worth of celebrities and politicians gets a lot of attention, but did you know that you have a net worth too? Net worth is just the difference between the value of all the assets you hold and the value of all the liabilities (debts) you have to pay.
Now, while the concept of net worth is easy enough to understand, the actual process of determining net worth is much more complicated. This is because net worth is not just about the money you have — it’s about all of your assets. And when you’re considering certain assets, it can sometimes be hard to estimate exactly how much they are worth. This is the reason why the net worth of a celebrity can often be misleading.
Fortunately, calculating the average person’s net worth is a lot easier than doing so for a celebrity.
If you have a high and positive net worth, then you can consider yourself financially stable. On the other hand, a negative net worth means you owe more money than you receive, and thus, you should consider trying to manage your finances better.
Net worth does not only apply to people. You can also calculate the net worth of an entity like a business or company.
When it comes to business, creditors will look at a company’s net worth to determine whether a loan is safe or risky. Creditors want to be sure the company can pay back the loan.
4. How to Calculate Your Net Worth
For an individual, examples of assets include, but are not limited to, the following:
- Real estate
- Savings accounts
- Retirement accounts
- Checking accounts.
Your liabilities also include the loans you currently have. However, future interest charges are not considered a liability yet, and should only be included once that interest comes due. Once you have subtracted your liabilities from your assets, you can see how much you are worth.
For an individual, liabilities include, but are not limited to, the following:
- Mortgage loans
- Credit card debt
- Student loans
- Personal loans
- Vehicle loans
If you have a mortgage on a house that is worth $300,000 and your loan balance is $200,000, then you can add $100,000 to your personal net worth.
When calculating your net worth, you do not include your income. This is because even if you have a high income, if you spend all of your money, it is not part of your net worth. On the other hand, if someone has a low income but he or she invests in assets and saves money, he or she may actually have a high net worth.
You can find net worth calculators online to help you determine your net worth.