Plenty of times I have been approached by young couples in their 20s or 30s with this question – “I think we should start investing, what do we do?” I answer their question with a question: “Are you ready to invest?” Typically I’m met with a stare and a reply that goes like this – “Umm, I dunno, I’ve been told I should save for retirement, so I need to invest, right?”
“Correct” I tell them, “but first you have to take two steps back before you know if you’re ready to invest or not.” Then I show them my Financial Planning Order of Operations. It’s a one page handout that looks somewhat like this:
- Eliminate your bad debt
- Establish your rainy day fund
More often than not young couples think they’re ready for step 3, but when I dig a little deeper, I see they’re still spinning their wheels with step 1 and don’t know much about step 2, either. Step 1 – your bad debt – is typically your high interest debt, which generally comes in the form of credit cards.
Borrowing on your credit card, which happens when you don’t pay your bill down to zero by the due date, often comes with extremely high interest rates. The high rates are for two main reasons: 1) the debt is unsecured, meaning it’s not backed by a house like with a mortgage or a car like with an auto loan; if you don’t pay your debt, the credit card company won’t come and take the groceries you bought, whereas the bank will come and take your house if you don’t pay the mortgage, and 2) they make credit card companies a ton of money.
I don’t blame young couples for thinking they’re ready for step 3 and being unaware of steps 1 & 2. I feel our school systems have failed to teach us a basic understanding of how money operates. Here’s my attempt to teach in three paragraphs what we didn’t learn in nearly two decades of school.
When you lend at 7 cents on the dollar and you borrow at 22 cents on the dollar you’re spinning your wheels; you’re losing 15 cents on every dollar you put to work for you. Case in point, wanting to invest (lending) to earn 7% on your investment while you’re still borrowing at 22% by not paying off your bad debt first.
Earning 7% or borrowing at 22% is not guaranteed for either, but we do know that on average we can’t earn rates of return on our investments comparable to those charged on carrying credit card debt. Therefore, our best investment becomes completely paying off our bad debt. The best part about it, not only are you free of debt, but you’ve just guaranteed yourself an incredible return, and getting a return on your money is why you wanted to invest in the first place, right? Well, here’s an excellent return sitting right in front of you. When you pay off a credit card that charges you 22% you just got yourself a 22% return and that’s very hard to get with investing.
What’s the best approach to tackle your bad debt? I can’t paint with a broad brush because everyone’s situation is different, but a good start is to rank your bad debt from highest interest rate to lowest interest rate then cut back, scrimp and save and put everything you can towards your highest interest rate debt while still making your minimum payments everywhere else so you avoid late fees and additional interest rate bumps. When that highest interest rate debt is paid off then move onto the next one until you are completely free of bad debt.
And now you’re ready to establish your rainy day fund. Your rainy day fund is simply cash in the bank or in your mattress if you’re one of those people. The unexpected happens – it’s one of the few things that can be expected in life – it’s a job loss, an accident, an appliance going out, or your car not starting. You need your rainy day fund to cover these expenses so you don’t go back into credit card debt. But you also need your rainy day fund to cover several months of your living expenses if one of these unexpected happenings prevents money from coming in.
A general guideline for your rainy day fund is your average monthly living expenses multiplied by 3 if you’re single, 6 if you have a dependent, and 8 or more for a single income family or larger family. Obviously, the more months you have saved up the more comfortable your situation and the easier it is for you to avoid something unexpected completely derailing your life.
You do keep track of your expenses, don’t you?
Steps 1 & 2 are critical; they are the foundation upon which step 3 is built. They’re not completed overnight and they take time, but when you’ve eliminated your bad debt and you’ve established your rainy day fund only then can you answer “Yes” when asked “Are you ready to invest?”
To learn more about Michael Pensinger, view his Paladin Registry profile.
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