There’s more than one way to measure how financially well-off you are.
As a financial educator and former NFCC-certified credit counselor, I’ve talked to thousands of consumers and found that most people measure their financial success by looking at their annual income. If your income goes up, you assume you’re doing better financially, right?
Not necessarily. What if your income goes up by $10,000 a year, and your spending goes up by $15,000? Or your salary increases by $20,000, but you immediately take out a $50,000 car loan? Have your finances really improved?
These are some examples of why income isn’t always a great measure of financial success. Instead, I recommend focusing on net worth to assess your financial well-being. Not sure what the difference is between the two? Let’s break down the two concepts so you understand how to make changes that truly impact your financial success.
Read more: This is the minimum amount of savings you need to improve your financial well-being
Net income, also known as take-home pay, is the amount of money you make after all taxes and withholdings are taken out of your paycheck. It’s the amount of money you can actually spend each pay period.
When people talk about how much money they make, they usually refer to their gross income, or the amount they make before taxes and withholdings. But that number can be deceptive when used to measure financial success, since it’s not reflective of how much money you actually have available to spend.
On top of that, the gap between your gross and net income might be much wider than that of someone else at the same income level as you. Why? Your net income is impacted by how much money you have withheld from your paycheck for any and all of the following costs:
Retirement contributions
Health insurance premiums
State income taxes
Health savings accounts (HSAs)
Flexible spending accounts (FSAs)
Union dues
Child support payments
Wage garnishments
Many people I’ve worked with have trouble remembering the difference between gross and net income. To help you keep them straight, imagine you’re going fishing in a pond. Sure, there may be hundreds of fish in the pond, but you only get to eat the ones you catch in your net. Similarly, you only get to spend your net income, not your gross.
Your net worth is the value of everything you own (also known as assets) minus the amount of debt you owe (known as liabilities).
To calculate your net worth, add up the total market value of all your assets, including your cash, bank account balances, property, and investments. Then subtract the total amount you owe on all of your debt:
Net worth = Total value of assets – Total debt
Unlike income, which just looks at how much money you’re currently bringing in, net worth looks at the full picture of your finances. While your income certainly impacts net worth, all your financial behaviors, including spending, saving, and borrowing money, are factored in too.
You can increase your net worth by paying off debt or increasing the total value of assets you own without taking on new debt. Here are some specific examples of how to go about increasing your net worth:
Increase your income without increasing your spending.
Prioritize paying off credit cards and other high-interest debt.
Automatically deposit a portion of each paycheck to your savings or retirement account.
For short- and mid-term savings, such as your emergency savings fund, deposit the money in accounts that earn competitive interest rates, such as high-yield savings accounts (HYSAs) or CDs.
Invest your mid- to long-term savings into a diverse portfolio of assets. That might include real estate, stocks, and bonds.
If your employer offers a match on your retirement contribution, take full advantage of their match to get free money each paycheck.
There’s no question that it’s good to have both a high income and a high net worth. However, if you have to choose between the two, it’s better to have a high net worth.
If you increase your income but not your net worth, you may feel or appear wealthier, but you won’t actually be wealthier.
For example, let’s say you’re one of many Americans who suffer from lifestyle inflation, meaning every time your income increases, your spending increases too. If you fall into this group, a pay increase won’t get you closer to financial stability or retirement, since your pay increases don’t result in an increase in your savings.
Or worse, you might even accrue debt faster than your income grows. In that case, you’ll eventually have a negative net worth, meaning the amount of debt you owe exceeds the total value of your assets.
By contrast, if your net worth is high enough, you may not even have to worry about earning income. If you have enough money in savings and your house is paid off, you can potentially live off what you have saved and retire early.
Read more: Financial independence: What it means and how to achieve it
Or you can earn passive income, meaning income from sources that don’t require you to actively work. For example, you might earn money from rental properties or returns from stock investing.