A few things you need to do before you start investing
In order to make the most of investing opportunities we have to establish certain ground rules. They are simple but very essential to your financial health and on going wealth management. It is highly recommended that you follow these steps in a particular order so that you make the most out of your hard earned dollars.
One of the first things you should do is set up an emergency fund. What this does for you is it serves as a safety cushion for any unplanned expenses. These unplanned expenses or emergencies can be anything from your car breaking down to unplanned house repairs, health care bills etc. You can’t predict certain life events. Therefore your emergency fund will be there to protect you. From the financial standpoint this fund will make sure your cash flow allocations remain steady and properly distributed across your targeted accounts.
Let’s say that John doesn’t have an emergency fund. Suddenly his clutch goes out (Should’ve bought German) and he needs to replace it. The bill is $1,700 (Ouch!). He had to put it on a credit card which collects a 13% interest. John is obligated to pay $221 a month as a minimum payment on interest only. Considering that he nets $700 a month (after all expenses are paid), he’s got himself in a doozy of a situation. Here is the break down of John’s case from two different perspectives.
This is to show the power of an emergency fund can’t be underestimated. Without the fund John struggled for 4 months to pay the credit card off while slowly building his first emergency fund (he learned his lesson about having the fund in the first place). In the second case, he paid off his unexpected expense immediately while still being able to replenish his emergency fund and invest some money on the side (for the simplicity we assumed John bought stocks through a stock discount plan at his company at 10% discount rate). The size of your fund will depend on your personal/family situation. Usually families of two with no kids would require somewhere in between $1,500-$2,500.
Credit cards can be deadly. As we learned from the example above: it can take quite a bit to pay them off, you end up paying high interest and you don’t get to invest until you pay them off! Investing while paying off credit cards doesn’t make a lot of financial sense. Let’s walk through our basic financial framework. First, you need to establish an emergency fund. Second, you already have to pay a 10-20% interest rate. Third, investing can be risky and it doesn’t promise a satisfying return all the time. Therefore you would be jumping the gun by trying to allocate small amounts towards investing and skipping a crucial step of building an emergency fund.
Credit cards should be the first thing on your “to pay off” list, once an emergency fund is in place. Your credit score is very important these days, so using a credit card for things like gas, snacks etc. is absolutely appropriate- under one condition: pay it off within a month.