Why You're Probably Deeper in Debt Than You Think
When starting a financial plan to get you where you want to go, one of the first steps is determining where you're starting from. A key measurement to determine where you're currently at financially is figuring out your net worth. Most simply put, net worth is the total value of everything you own minus any debts.
Assets - Liabilities = Net Worth
Most people can figure this out pretty easily. Add up the value of your home, car, savings accounts, etc., then subtract you mortgage, car loan, personal loans and credit card balances. The difference is generally considered your net worth, but it's probably not as clear a picture as you want.
What is Unrealized Debt?
While the standard method for figuring your net worth does a great job of laying out all the assets and debts you have on paper, it falls short of showing you your true financial starting point. When people have debt on paper, it's also common(if not standard) for them to put off necessary expenses in addition to accumulating that debt. These deferred expenses range from doctor visits to home repairs and they are expenses which must be paid eventually, but because they have been put off, they don't show up on paper. I call these types of deferred expenses, "unrealized debt".
Unrealized debt, like any debt, can accrue "interest". It's not at any stated interest rate like you'd find on a credit card statement, but a particular unrealized debt does grow the longer you do not pay it.
Let's say your brakes start to squeak a little because the pads are wearing. The initial cost to repair is about $200, but you put it off. Six months later the the pads have completely worn and are now grinding down your rotors. Now the costs of your repairs and unrealized debt has grown to $500+. That debt increased at an annual percentage rate of 300%!
Modified Net Worth
Consider the compounded costs of deferred dental work, plumbing repairs, doctors visits and other routine maintenance when creating a financial plan. Take some time to calculate the costs of every necessary expense you've put off and arrive at a total for all unrealized debt. Now you can take a more accurate inventory of your overall financial health by determining your modified net worth.
Assets - Liabilities - Unrealized Debts =
Modified Net Worth
I believe determining your modified net worth gives the most accurate picture of your current financial situation and will better help you decide what areas to immediately focus on. Usually people are eager to jump right into wiping out traditional debts like credit cards and student loans, believing that once those debts are paid they'll have a clean start.
However, in many cases, unrealized debts should be paid off before traditional debts as unrealized debts can be both more costly to defer and can do more to improve your quality of life when paid. Paying off unrealized debts needs to be a part of your financial plan. List out any unrealized debts you may have and estimate the potential added costs of deferring them any longer. With this information you can decide which unrealized debts to tackle first and which may be able to wait a little longer while you pay down your traditional debts.