How Do I Generate a Net Worth Forecast?
First, recall the fundamental balance sheet equation: Net Worth = Total Assets – Total Liabilities
We arrive at a net worth forecast by forecasting all assets and all liabilities as far into the future as we want. At any future time-point, the net worth estimate is the difference between total assets and total liabilities. Below I provide some guidance on how to come up with conservative and aggressive forecasts for a variety of assets and liabilities. If your conservative and aggressive scenarios are legitimately on the extremes, a reasonable forecast may be to average the two. Some items are easier to forecast than others. I assume a ten-year forecast horizon for this discussion.
Notation: X^Y is read as X to the power of Y. Thus, (1+r)^t is read as "(1+r) to the power of t," and 1.05^10 means 1.05 to the power of ten.
Forecasting the value of your home:
If properties in your neighborhood have appreciated at an average annual rate of 3% over the last two decades, you could choose to assume this same growth rate will apply annually into the foreseeable future. It may also be useful to consider a separate scenario under which growth rate is a more subdued 1%.
Take your home’s current value and multiply it as follows:
Forecasted Value at time T in future = Current Value x (1+r)^T,
where T may be five, ten or twenty years in the future, and r is the appropriate growth rate. In this case r=1% or 3% annually, depending on the scenario.
If your home’s current value is $300,000 and your forecast is for a ten-year horizon, then:
Conservative scenario: Forecasted home value in 10 years = 300,000 x (1+.01)^10 = $331,386
Aggressive scenario: Forecasted home value in 10 years = 300,000 x (1+.03)^10 = $403,175
How do you estimate your home’s current value?
If you bought the home recently, you can simply use the recent sale price as a reasonable estimate for today’s value. If the home is older, you can use some of the popular listing sites such as zillow.com or realtor.com to identify recent sale prices of similar homes in the same neighborhood, to get an idea of how much your home is worth. If you apply for a home equity line of credit from your bank or discuss selling your home with a real estate agent, professionals at either institution may be able to give you a formal or informal appraisal of your home’s current value.
Forecasting investment account balances:
If you have an old account (one that is no longer active with an employer) you only need to estimate an average annual growth rate and apply that to your current balance, compounded an appropriate number of periods to obtain a future value at your desired time point. In our example that’s ten years. If your account funds are invested in stocks, you may want to use a conservative 6% annual return or a more aggressive 8%.
For example, suppose you had a 401(k) account with a prior employer, and rolled that into an IRA after you left that job. The IRA is invested in stock funds only and has a current balance of $175,000.
Conservative scenario: Forecasted IRA value in 10 years = 175,000 x (1+.06)^10 = $313,398
Aggressive scenario: Forecasted IRA value in 10 years = 175,000 x (1+.08)^10 = $377,812
Next, let’s forecast the growth of a 403(b) account balance with your current employer, assuming the current balance is $50,000. There are two factors contributing to forecasted value of a retirement account with a current employer. One is the growth of the existing balance, which is calculated exactly the same way we calculated above for the IRA. You simply compound its current balance into the future:
Conservative scenario for existing balance: Forecasted 403(b) value in 10 years = 50,000 x (1+.06)^10 = $89,542
Aggressive scenario for existing balance: Forecasted 403(b) value in 10 years = 50,000 x (1+.08)^10 = $107,946
The other factor arises from the observation that you’ll likely continue to contribute into the account every year (in practice you’ll contribute from your paycheck every month or two weeks). Thus, in addition to forecasting growth for the current balance, you need to forecast growth for every new contribution. You could model every monthly contribution separately, but for our purposes it’s much easier to just assume that you will make one large contribution once at the end of each year. You could make a different assumption. Assuming the contribution is made at year-end is fairly conservative.
Suppose your current annual contribution to your 403(b) is $12,000. Your employer’s match is $6,000, for a total annual investment of $18,000. We need to track the growth of each new contribution, until the forecasted date. In this case, that’s ten years in the future.
Conservative scenario for future contributions: Assuming each contribution will compound at 6%, this total accumulation amounts to $237,254. (See accompanying spreadsheet for detailed calculations)
Aggressive scenario for future contributions: Assuming each contribution will compound at 8%, this total accumulation amounts to $260,758. (See accompanying spreadsheet for detailed calculations)
The total accumulations under each scenario comprise the growth of existing balances and future contributions.
Conservative scenario for total future accumulation: $89,542 + $237,254 = $326,797
Aggressive scenario for total future accumulation: $107,946 + $260,758 = $368,704
Note: In reality, your contributions will likely grow each year as your base salary increases. This means your total accumulation would be even higher than that described here. For example, assume contributions grow on average at 3% annually. At the end of this year you’ll contribute $18,000, at the end of next year you’ll contribute $18,000x(1.03), the next 18,000x(1.03)2, etc.
Forecasting the value of a car and the balance owed on a car loan:
On the asset side, your car is likely to lose value over time, while on the liability side your car loan principal outstanding declines over time as you make payments.
Loss of car value over time can be estimated simply. For example, assume a vehicle will lose all or most of its value over eight years and reduce the value in your balance sheet by 12.5% (an eighth) each year. You could instead look up predicted valuations of various used car models online, resulting in a non-linear depreciation pattern of car value. Since cars are depreciating assets we don’t look to them to build our assets, so it doesn’t really matter if our car price forecast are very accurate. Generally, I ignore the value of cars when calculating my household net worth. The only reason you should do otherwise is if you legitimately have a collector-car whose value is expected to hold up over time.
Principal payment is usually quite easy. If your car loan is has a five year maturity and is designed to give you full ownership without additional payments at the end of the loan period you can simply assume your loan balance will decrease by 20% each year, until it goes to zero.
If you’re doing a long-term net worth forecast, for example, 20 years, you can assume that after 6 or 8 years the car’s value goes to zero and a new one is purchased. When the new one is purchased, your car value and loan balance both reset to higher values and the whole pattern thereafter repeats itself, with both the loan principal and car value decreasing over time.
Forecasting the principal owed on a property purchase, including your home:
Assuming you have a fixed rate loan, your principal owed on the mortgage is amortized over the life of the loan. Most fixed-rate loans are 30 or 15 year loans. While your monthly payment (principal and interest) is the same every month for a fixed loan, over time the portion of each payment that goes to paying principal increases while the portion covering interest decreases. For example, when you first take out the loan 80% of your payment accounts for interest, while only 20% goes toward the principal. Over time the percentage that goes toward principal increases, until your final payment is 100% principal and the loan is paid off.
Forecasting credit card balances:
If you always pay off your entire credit card bill each month then at any point in time your credit card balance will be a reflection of a typical month’s expenses. In the future you can expect those expenses to rise by the rate of inflation.
Assume your monthly credit card balance is $3,000 and the inflation rate is 2% (This is the rate targeted by the US Federal Reserve). Ten years into the future you’d expect your typical revolving credit balance to be:
Forecasted credit card balance in 10 years = 3,000 x (1+.02)^10 = $3,657
If you think your household credit card balances will grow at a rate faster than inflation you can easily accommodate by increasing the growth rate in the above equation.
It’s a completely different story, however, if you don’t pay off all credit card balances in full at the end of each month. Interest rates on outstanding credit card balances are ruinously high, on the order of 20 to 25% annually. In such cases many borrowers find it difficult to reduce the outstanding balance, effectively turning it into a long-term debt that is more likely to grow than to decrease in size. You must avoid such a circumstance.
Putting it all together
Once you’ve got all your asset and debt forecasts you can bring them together in a hypothetical net worth or balance sheet statement for your forecasted time point. In our case that timepoint is 10 years in the future.
You can create one forecast using the conservative outcomes and one using the aggressive ones and compare them. If your conservative and aggressive scenarios are truly extremes, then the most likely net worth outcome for you will likely lie somewhere in between the two forecasted scenarios.
In this chapter we engaged in a high-level view of debts and assets. The next two chapters provide, respectively, deeper examinations of the debts we are likely to accumulate and the different assets (pillars) we should strive to build over time.