Invest In Yourself: 3 Steps You Need to Take Before You Invest
A guide to debt freedom for financial novices
I was on Status Money the other day, and a question came up. A user asked, “How do I start investing in the stock market.” The user gave some background; he or she is 25 years old, and they have some debts which they’re ahead on. They’re currently contributing a large percentage of income to his/her 401K, and they know a little about the market.
Some people gave them advice that boiled out to “Use my Robinhood link.”
I decided to take a bit more of an in-depth look, and I congratulated the user for thinking about investing at such a young age. No matter what age you are, it’s better to get into investing than to not because your money will lose value over time with inflation if you leave it in the bank.
I wanted to know more about the person’s finances to make more educated suggestions. I started to ask questions; I wanted to get to know the person’s financial situation and didn’t just want to give a canned answer.
I asked him (I’ll run with the assumption that the user is male for the purpose of this post) what kind of debt he has (credit card debt, student loans, etcetera), and what was the employer match for the 401K.
He mentioned he is investing 12% of his income into his job’s 401K! His company has a 50% match up to $17,000. He also says he has the usual debt: credit card, student loans, car note, personal loans, and a mortgage as soon as he closes on the house he’s buying.
I’ll share with you what I shared with him. I like to write for people who are new to personal finance. So if you’re already well established financially, this may not be the best article for you.
However, if you’re one of the 40% of Americans with less than $400 in savings, or one of the 55% of Americans who carry credit card debt month to month, I hope you stick around and keep reading.
I’m a follower of Dave Ramsey’s 7 Baby Steps to Financial Freedom. While I don’t follow his guidance to the letter, I like to emphasize the first three baby steps. Most people have trouble starting their journeys to financial freedom, and just being able to understand and follow the first three steps will put you ahead of the average American.
Step 1: Start an Emergency Fund
The emergency fund is essential because it keeps you from using a credit card when an unforeseen expense comes up. There is a study that says 40% of Americans cannot handle an unexpected expense of $400 without using a credit card.
Setting up an emergency fund is the first step for a very critical reason. If you try to skip this step and go straight to step 2, you may find yourself continuing to use your credit card if unexpected expenses occur.
An emergency fund gives you a buffer between yourself and the unexpected. Where the emergency fund is concerned, larger is the better, but you should start off funding it with no less than $1,000.
I don’t think many people think of saving $1,000 as a critical step to investing in yourself. Let me describe a real-life example of how critical having $1,000 in your emergency fund can be.
Up until recently, I was driving a five-year-old car. My car started having some problems accelerating, so I took it to the dealership to have it checked out. By the time the dealership recommended all kinds of services to me, the bill was up to $2250. Once I eliminated all of the recommendations that had nothing to do with the vehicle accelerating, the bill came down to around $750.
I did not budget to spend that $750. However, I view having a reliable vehicle is a necessity, so I paid the bill. If I didn’t have an emergency fund, I would not have been able to afford to pay the bill. Either I would have to drive an unreliable car and potentially risk it breaking down or getting into an accident, or I’d have to carry a balance on my credit card. An emergency fund with $1,000 helps avoid both of these scenarios.
Step 2: Pay Off Your Debts
Debt repayment is a form of investment where you’re guaranteed a return in the form of interest that you’re no longer paying the debt holder. So if you have a credit card that has like a 16% annual percentage rate and you pay it off, it’s like getting a 16% return on the investment guaranteed!
Step 2 is focused primarily on consumer debt (things like credit cards, car notes, and store cards). Ramsey recommends focusing on mortgage repayment in later baby steps. This area is one he and I differ on. I wouldn’t include student loan debt in this step, especially considering student loan debt for many people is five figures for some of us, even six figures.
There are two keys to being successful in step two. The first is to stop using carrying balances on your credit cards. The second is to use the Debt Snowball to repay your debts.
Yes, the Debt Avalanche saves you more money in the long run by first paying off higher-interest debt. But the Debt Snowball is easier to stick to because you get to see your smaller debts paid off early, which helps consumers build confidence that they can become debt-free.
The Debt Snowball allows you to organize your debts from the lowest balance to the highest balance. You pay the minimum payment on all debts but the one with the lowest balance.
You take all your available funds and pay the lowest balance off as quickly as possible.
Once that original lowest balance is paid off, take that money that you were paying toward the first debt and add it to the minimum payment for the next lowest balance. Now use that new higher payment to pay off the 2nd debt.
You’d repeat this process until you’ve paid all of your consumer debt. This payment method allows you to get some quick wins and build momentum in paying down your debt.
Debt Repayment and Coronavirus
I understand that with many Americans currently unemployed right now, paying off your debts may be the last thing on anyone’s mind. However, if you are fortunate enough to be employed, you still have the power to pay off your debts. If you are reading this and are not currently employed, I may have an article that can help you get by for the time being.
Many companies allow people to defer their debt payments for the foreseeable future in light of the coronavirus. If your creditors are among this group, you may be able to call them and have your monthly payments deferred. I would recommend having all but your smallest monthly bill delayed if you can. That will allow you to focus on paying that one bill much more quickly. When that smallest bill is paid, you can pay down the next bill as per usual in the Debt Snowball. However, if you pay while the debt is being deferred, 100% of your payment goes towards your debt’s principal, making your debt repayment go even faster!
A Word Of Caution
This area is another where Ramsey and I disagree. Notice, I didn’t recommend that you stop using your credit cards, or tell you that credit cards are evil. They are simply a tool. If you carry a higher balance than you can repay every month, it’s a tool to make the credit card companies rich(er). If you use it to cover your regular expenses and pay the balance off every month, it becomes a tool to build your credit and take advantage of the credit card company’s incentives.
Going back to my car repair example, I could afford the $750 fee because I had the money in my emergency fund. However, I did not pay the car dealership out of my checking account. I paid using a credit card that gives me cash back incentives. I was able to pay the balance in full at the end of the month and take advantage of the card’s cashback incentive. However, this means that I also had to go back to step 1 and put the $750 back into the emergency fund.
It’s essential that you repay your emergency fund after you’ve used it.
Step 3: Fully Funded Emergency Fund
After you’ve set up your emergency fund and paid all of your consumer debt, you may think you’re ready to start investing. I would advise against this. What happens if you experience a financial setback that is more significant than $1000? That’s why you must go through each baby step to protect yourself and your finances.
Your third step is to save 3 to 6 months’ worth of income to fund your emergency fund fully. What you can do is take all of the money you were applying to step 2 and apply it towards step 3. That will give you at least 3 months of your income set aside in the event of a major life event like the loss of a job.
You’ll want to do some personal finance house cleaning before you start investing in the stock market. It’s in your best interest to eliminate all consumer debt before investing in anything. You’ll want to begin your emergency fund, and fully fund it with 3 to 6 months of income before investing. This way, you’ll be appropriately insulated against unfortunate life situations.
This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.
The Mini Post-Grad Survival Guide
A 5-day email course with tips on budgeting, investing, and productivity for 20-somethings. Sign up for free.