My past article on tracking your progress has a simple calculator where you can track whether you are accumulating wealth at a *sufficient* rate to achieve financial independence. This was based on a formula shared by Dr. Thomas Stanley in his excellent and meticulous research in his book “The Millionaire Next Door”. This book demystified how the affluent live and totally debunked the media-fueled imagery of the supposed lifestyle of the rich.

The rich don’t live differently from you and me, at least most of the rich people anyway. Barring exceptions such as celebrities, business moguls and hedge fund managers, a large majority of affluent people live quite ordinary or even modest lives. In fact, it is this under-stated lifestyle that enabled many of them to acquire wealth in the first place. They are not enamored by any of the so-called ‘status symbols’, preferring instead to add substantive value to society through their business, charitable and other social engagement work.

Many are happy driving their old Toyotas or Hondas and look for free parking – as some of their financial planners say – when they meet to discuss their seven figure portfolios! Even their charitable philosophy is driven by their interest to add tangible value to under-privileged people and under-served sectors of human life (such as arts/humanities). They prefer real results rather than garish publicity-seeking monuments to their charity. This is a key takeaway for me from that book.

The famed wealth tracking formula from the book, which is a subject for this article, is:

##### Age x Annual pretax income / 10 = Expected or Average Net Worth.

My calculator allows you to determine whether you are Wealthy (**PAW** or *prodigious accumulator of wealth*), OK (**AAW** or *average accumulator of wealth*) or Struggling (**UAW** or *under accumulator of wealth*). Use this as a starting point before you read the rest of the article.

Recently, an article on this subject from Fritz @ Retirement Manifesto where he graciously linked my embedded calculator, covered the same formula for tracking your progress.

Both our articles generated a number of interesting comments. Despite the caveats we both mentioned in our articles about its limitations, a formula like this to track your progress in relation to your income and age is very useful. It gives you a navigational yardstick in your career and life journey. An earlier article by Mr. Money Mustache on the larger topic of “how rich are you?” generated a large number of comments where the above formula was mentioned but interpretations differed on what’s included and how to address different scenarios.

By tying the formula to age and income, the good professor has already *partially* levelled the playing field by saying that either higher age or higher income generally means more is *expected* from you in terms of net worth.

I have been thinking about this and found there is a key limitation in Prof. Stanley’s formula. It doesn’t differentiate between the ** type** of assets in your net worth. Consider this example:

Joe Average is 35 years old and makes $50,000 in salary from his work. His expected net worth based on the formula is $175,000. He is an **AAW** if he has that much in net worth. Let’s say he does but most of it is tied up in his house that he owns. Let’s assume, he has a house worth $300,000 where his home equity is one half of that and has a remaining mortgage for the other half ($150,000). Together with $20,000 of other assets in his retirement accounts, a savings account and a small car worth $5,000, he has a net worth of $175,000. In other words, he is an average accumulator of wealth (AAW) as per the formula’s definition.

Say he has a cousin, Joe Renter, who is also of the same age and makes the same income and also has the same net worth as Joe Average. He is an also average accumulator of wealth (AAW) as per the formula’s definition. But Joe Renter’s $175,000 net worth is comprised entirely of his retirement accounts, after-tax brokerage accounts and the same used car worth $5,000 that he uses to commute. Being a frugal guy that he is, Joe Renter doesn’t own a house but rents a studio apartment in a lower cost neighborhood in his town for just $400 a month.

The formula from *The Millionaire Next Door* doesn’t differentiate between Joe Average and Joe Renter. Both are rated UAWs with the same ratio of 1.0 that you get if you plug in the numbers into the calculator above.

*Yet, there is a vast difference between them. *

If you apply the 4% rule, which works only on investable assets, the safe withdrawal rate for Joe Renter would be $6800 per year (4% of $170K invested net worth) versus only $800 a month for Joe Average (4% of $20K invested assets). The home equity that Joe Average has – while it has a tangible value – has no cash flow return.

Even if the mortgage is fully paid for, Joe Average has to continue to pay property taxes and periodic repairs for the rest of his life on that house, which offsets the monthly rental cost that Joe Renter has.

The equity value of the home may continually increase, at least on par with inflation, so including that as an asset in net worth is valid. Also, Joe Average has the option of converting a fully paid off home back into a monthly income by either a reverse-mortgage or selling the home and moving to a rental property any time he chooses. But these are not equivalent choices to an unencumbered investment portfolio.

The wealth formula, by not correcting for the difference in invested assets, treats home-owners and lifelong renters alike. So, how do we correct for it? Should we remove home equity entirely from net worth in the formula? Doing so would bias the formula in favour of renters and *against* homeowners, who have equity value in their homes, no matter how illiquid that is.

To arrive at a balance, I thought about correcting the formula to remove bias towards both. So, I present a calculator below that home-owners can use, whose output can be compared to another one below that renters can use. Note this ‘correction’ only applies to primary home-owners, not people with real-estate investments. If real estate is the route to your FI, then you should use the renters’ calculator below where you treat the equity value of investment real estate the same way as you would treat your stock/bond portfolio value. That is, include them in net worth. But don’t include your primary home.

*Hover your mouse over the Net Worth field to see important differences in both calculators.*

Though they appear similar, there is a significant difference. The home-owners’ ratio in the formula is divided by **8** instead of **10** for renters. The 10 divisor is what the original formula says. By removing primary home equity entirely and applying a lower divisor, we are doing two things for home-owners here. We first recognize that Joe Renter has a better wealth profile than Joe Average because an investment portfolio of the same value as home equity counts a bit more from a wealth accumulation standpoint because of the cash flow generation potential and a *more definitive* value of financial portfolio rather than real estate. However, home equity still has value as a rental substitute, so that’s where a lower divisor comes in.

Note that 1/8 (0.125) is ** 25% higher** than 1/10 (0.1). So, the formula compensates home-owners for having removed their primary home equity value from the calculation by valuing their investment assets higher.

By doing this, Joe Average will be a UAW in this formula while Joe Renter remains a AAW. Can you see why?

To understand this better, consider a case where Joe Renter and Joe Average will be truly ‘equal’ AAWs. For this to happen as per the revised calculators above, Joe Average’s home equity should be no more than 20% of his net worth – in other words, 20% of 175,000, that is $35,000. Subtract this figure from Joe Average’s net worth to get an *investible* net worth of $140,000. These assets are valued **25%** more for the purpose of the new calculation since we have subtracted an equal amount ($35,000) from the net worth by ignoring the primary home’s equity.

*This is the wealth neutral point in terms of what percentage of total assets can be tied to primary home equity.*

Despite a lower investable net worth, Joe Average is equal to Joe Renter for the progress on wealth accumulation because of the consideration of additional equity owned by Joe Average in his primary home. Up to a point. The revised formula also acts as a ceiling for *how much* of your net worth should be tied in primary home equity. Using the same example above, by having most of his net worth tied up in the home, Joe Average will fare worse than Joe Renter in the new formula.

Some of you may wonder, what’s wrong with having most of your net worth tied to your primary home? It is, after all, an asset. The problem here is, a home is not a cash flow-generating asset. It does provide an alternative to renting cost so to that extent it deserves some consideration but that is offset by growing periodic expenses tied to owning a home – mainly, property taxes, insurance and repairs – that renters don’t have.

In some American towns, property taxes are so high that you can rent a nice apartment on that money alone! Still, the fact that a homeowner owns valuable equity in the home deserves some recognition. In the revised formula, I have given the credit in the form of accelerating the rest of your assets – as a reminder that’s where a home-owner should focus and not so much on home equity alone.

So, did you try the revised calculators above? How do you fare now? Please share your views on this approach.

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