If you’re like most people, you have more ideas about what to do with your money than the amount of money, itself. So, you have to prioritize. Should you save, pay down debt, or invest? Here’s what we suggest for most people.
Priority 1: Pay the minimum on all your bills and debts
Pay the minimum on everything so you don’t get hit with fees or hurt your credit
Your first financial priority should be to cover the bare minimum on all of your bills. If you don’t, you’ll likely be hit with fees that effectively have usury interest rates.
Priority 2: Build your Tier 1 Emergency Fund
Build an emergency fund that can cover 2 months worth of living expenses
So, why save first? Life can throw a number of curveballs your way at a moment’s notice–car accident, physical injury, family emergencies, and the like. If you’re short on cash, you’ll likely have to scramble for funds. This may cause you to be late on minimum payments (fees!) or you may have to pay unsavory interest and fees to borrow. The best way to prevent this is to prepare for it–by saving the bare minimum of 2 months of living expenses.
Priority 3: Contribute to employer-matched investment plans
Contribute enough to your 401K or 403b plan to fully get your employer match
Most employers that offer a 401K or 403b (i.e. 401K for the public sector) will match a portion of your contributions up to a certain limit. This is essentially free money, so if you’re eligible–some employers may require you to work for a year or two before you are–you should absolutely contribute enough to get the full match. For example, if your company pledges to match 100% of your contributions up to 6% of your earned income, you should try your best to contribute at least 6%. If your company matches 25% up to 8%, you should invest at least 8%.
Priority 4: Build your Tier 2 Emergency Fund
Add to your emergency fund so you can cover an additional 2-4 months of living expenses
In the same spirit of setting up the aforementioned Tier 1 emergency fund, you should contribute to your emergency fund so you could cover more drastic events, such as being let go or laid off. The exact number of months of reserve you should keep is truly dependent on your unique situation. For example, if you have a very stable job in a high-demand industry (e.g. you work as a nurse) then you’re probably safe with just 4 months of reserves. However, if you’re typically in temporary roles in a highly cyclical industry (e.g. you work as a construction worker), then you should probably have 6 or more months of reserves.
Priority 5: Pay down high-interest debt
Pay down debts that have an interest rate of 6% or higher
Once you’ve built an emergency fund, your next challenge is to figure out if it’s more immediately beneficial for you to pay down your debt or invest your money. The long-term return from investing in the S&P500 is about 10%. By not investing, you’re essentially losing out on earning 10% annually. So, should you only pay down debt that has an interest rate over 10%? Perhaps, but there is no guarantee future returns will be the same as past returns. In addition, the stock market fluctuates wildly, so you could lose money next year even if you’re significantly better off in 30 years. To balance the risk of investing with the opportunity cost of not investing, we recommend paying down all debt that has an interest of 6% or higher first before investing. You can adjust this threshold based on your risk tolerance. If you’re comfortable with more risk, raise the threshold to pay down debt first at 8 or even 9%. If you’re not as comfortable with risk, set the bar at 4%.
Priority 6: Buy a home
Buying property that you strongly believe will appreciate in future can help you build your net worth
Once you’ve paid down your high-interest debt, consider buying property you can afford and that you think will appreciate significantly in the future. In the long term, buying a home is not always cheaper than renting, contrary to popular belief. However, for most people in most circumstances, buying a home rather than renting does prove to be more advantageous. The most notable exception is when a house barely appreciates or even depreciates over time.
Priority 7: Max out your tax-advantaged investment accounts
Hit the maximum contribution limit on your tax-advantaged investment accounts before investing “naked”
Tax-advantaged investment accounts, such as 401K, IRA, and their Roth variants, offer tax advantages now or in the future. For most people who start contributing from an early age and contribute fully to these accounts, the advantages will be worth hundreds of thousands of dollars. While you may have a 401K or 403b from work, you may be eligible to open an IRA if you haven’t already done so. Max your limit on your tax-advantaged accounts first, then invest through a standard brokerage account.
Priority 8: Invest outside of tax-advantaged accounts
Invest in a diverse set of asset classes to build passive income flow and long-term wealth
By making it to this point, you’ve successfully created a sturdy and well-solidified financial foundation. You can tough through turbulent times, and you’re ready for any uncertainties the future may throw your way. Your next step is to build passive income (e.g. earning money without working) and long-term wealth. There are many ways to do this, and we’ll tackle them in our future articles. If you haven’t done so already, make sure to sign up to get notified of our latest content and publication releases.