Debt and Savings: Initial Moves for Effective Investing
Tackling your debts and saving money are prerequisites to investing and building wealth. Here are 5 ways to tackle your different financial priorities.
Before investing, there are a few financial priorities to address that, if left alone, could limit the overall growth of your dollars.
Paying off high interest debt and contributing to your employee sponsored retirement plan are prerequisites for general investing.
Building a safety net of three to six months can ensure your future financial security.
Whether you’re a new graduate navigating your first full time job while facing intimidating student loan debt or if you’re a seasoned professional who is newly focused on taking control of your finances, it can be overwhelming to figure out where your dollars can work the hardest for you.
In this article, I’ll be providing some best practices that should set you on the path to becoming debt free, without sacrificing your future financial goals and savings plans.
Always pay your minimum debt payments.
To the best of your ability, always make at least your minimum debt payments on time. Not keeping up with minimum payments will hurt your credit score and can load you with extra penalties, interest, and fees. Everyone’s financial situation is different, but making minimum debt payments on time is of paramount importance.
Setting up automatic payments can help ensure you never forget to keep track of due dates. In addition, many lenders will work with you to consolidate loans, refinance, or lower interest rates. If any of these options seems appealing to you, it may be worth contacting your lender to inquire about your possibilities.
Take advantage of employer-sponsored matches.
Now that you have your minimum debt payments under your belt, this next step depends on whether or not you have an employer sponsored retirement plan with an employer match. If you are fortunate enough to be covered by an employer plan that has an employer match, you will want to take full advantage of those “free” dollars. For example, an employer may match 100% of the first 6% you contribute.
Receiving a match from your employer for each dollar you contribute to your 401(k) is by default a 100% return on your investment. You’ll rarely find this kind of return elsewhere.
Pay off high interest debt.
While all financial advisors define high interest debt differently, at Betterment we take a conservative route and consider any debt with an interest rate greater than 5% to be high interest. Debt that has an interest rate of 5% or higher may snowball more quickly than the growth you can expect from your investments when you factor in short term market fluctuations.
Over the last 20 years the U.S stock market has returned about 8% per year on average, but 8 of those years had returns well below 5%. Ultimately, your dollars should go further by paying down this high interest debt. If you have debt with an interest rate below 5% you are likely better off paying the loan back on schedule and investing your extra funds.
If you have multiple loans with high interest rates you should aim to fully pay off the highest interest loan first before making payments towards other loans.
Build, but don’t overfund, your safety net.
Once you tackle your high interest debt and maximize your employer match, you can start building a safety net. A safety net should cover three to six months of fixed expenses and can be held in a savings account or a low risk investment account.
It may be tempting to overfund your bank’s savings account as it is familiar and safe, but this can be harmful to your financial plan in the long term. The general cost of living, healthcare, and education all increase each year. This is known as inflation. Inflation can eat away at the amount of goods and services your dollars can purchase. This is one reason why we encourage customers to limit their excess cash savings and begin investing for their long term goals using an appropriate mix of stocks and bonds.
Having a fully funded safety net is a critical part of any good financial plan. These funds provide some breathing room should you lose your job or encounter a large unexpected expense. The goal for your safety net is to be able to fund emergencies without going into debt, and should not be where you build up your portfolio.
Invest for your long-term goals.
While retirement is likely your largest and most pressing financial goal, different timelines, values, desired lifestyles, financial goals, and tolerance for risk can impact your financial priorities. This is why creating and implementing a personalized financial plan is so important for keeping you on track.
Everyone’s financial situation is different, but hopefully using this road map can help you make smarter decisions when it comes to securing your financial future.
Organizing your debt payments and savings plans are crucial prerequisites to investing.
Betterment can help you create a full retirement plan, set up spending goals, and invest your savings appropriately using our automated investing tools. However, we know sometimes you just want to speak with a professional. Our team of CFP® professionals can help with your financial plan whether you are ready to invest or not. With an efficient and disciplined plan in place, you can be on your way to investing for your future sooner than you may think.
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