3 Steps You Need to Take Before You Invest
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 like he or she is 25 years old, 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 basically 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 just leave it in the bank.
I wanted to know more about the person’s finances in order 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 just give a canned answer.
I asked him (I’ll run with the assumption that the user is male for the purpose of this blog) what kind of debt does he have (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 gave him some advice I’d like to share with you today.
Your money will lose value over time with inflation if you just leave it in the bank.
I like to echo Dave Ramsey on occasion when giving my opinion on personal finance. I’m a follower of Dave Ramsey’s 7 Baby Steps to Financial Freedom, and I like to recommend that others, especially people with consumer debt do the same. I prefer to emphasize the first three baby steps since most people have trouble starting their journeys to financial freedom.
The emergency fund is important because it keeps you from having to use 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.
40% of Americans cannot handle an unexpected expense of $400 without using a credit card.
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 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. 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 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 paying off higher-interest debt first. 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.
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.
You may think that after you’ve set up your emergency fund and paid all of your consumer debt you’re ready to start investing. I would advise against this. What happens if you experience a financial setback that is larger than $1000? That’s why it is important that you 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 fully fund your emergency fund. 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 also want to begin your emergency fund, and fully fund it with 3 to 6 months of income before investing. This way, you’ll be properly insulated against unfortunate life situations.