There’s a lot of talk about how much money you should have saved, how debt is the enemy and that you need pay it off ASAP, and that you should start investing as early as possible. This is all great information to have, but the fact is that when you’re young and you only have a small amount of money to allocate to these things, your fear of missing out on good money making opportunities quickly turns to information overload and then paralysis. How can you possibly save 6 months of expenses, max out your 401K contributions, and overpay each month on your student loans when you’re only making an entry level salary? If you still want to pay your rent and eat, you probably can’t. So most people do nothing because they become overwhelmed and don’t know where to start. If you’re one of the people who wants to make good financial decisions but easily becomes overwhelmed with all of the things you “should be” doing with the little money you have, you’re not alone. To help calm your anxieties and give you the confidence to start taking control of your finances, we’re giving you a roadmap for when and how much you should allocate to your savings, pay toward your debt, or invest.
Your first step is to make sure you’re paying all of your minimum debt payments on time. Debt is a financial obligation. That means, that you must make your minimum debt payment every month, no matter what. Making sure to hit every minimum payment is critical to building good credit and avoiding defaulting on your loan, which will wreck your credit score. To do this, you should take your debt inventory. Make a list of all of the outstanding debt you have, what the minimum monthly payment is for each, and when each payment is due. If you’re comfortable with setting up auto payments, I would highly recommend it. If you have multiple loans with varying due dates, you can call your lenders and ask them to move your due dates so all of your payments are due at the same time. This way, you can pay everything at once, and you don’t have to remember multiple dates throughout the month to make your payments.
Once you’ve set yourself up to meet all of your minimum debt payments, the next step is to start building an emergency fund. The best type of account to use for this is a high-interest savings account because they offer much higher rates of return than traditional savings accounts. A good rule of thumb for how much you need to have saved in your emergency fund is 6 months of expenses. Having closer to a year of expenses saved is better, but starting with a goal of 6 months of savings is great. Having an emergency savings is your foundation for financial stability. It is CRITICAL to your financial health that you build a savings account in case you ever lose your job or have large unforeseen expenses, like medical expenses. Remember in the previous paragraph where we discussed that your debt payments are financial obligations? If you lose your job, you still have to make those payments, and that’s where your emergency fund comes in. (For more info on emergency funds and high-interest savings accounts, see this post.)
Now that you’ve set up your emergency fund and are meeting your minimum debt payments, should you start investing any leftover money? As a rule, you should allocate as much as possible to your savings until you’ve reached your savings goal of six months of expenses saved. There is one exception though. If you’re offered a 401K with a company match, you should invest. A company match means that if you contribute to your 401K, your employer will also contribute a percentage of your contributions. If you have a company match, you should contribute up to the percentage of the match. For example, if your company matches 50% up to 5%, that means that you should contribute 5% of your income to your 401K, and your company will contribute an additional 50% of the 5% contribution you are making. 401K contributions are pre-tax, which means they come out of your earnings before any other deductions are made. So if you make $50k/year, and contribute 5% to your 401K, you contribute $2,500/year. If your company matches 50% of that, they will also contribute $1,250/year. That makes your total annual 401K contributions $3,750. If you’re offered a company match and you aren’t investing in your 401K, you’re leaving money on the table. Once you’ve set up your 401K contributions to meet your employer match, you should follow the savings rule above and allocate any extra money to your emergency savings until you reach 6 months of expenses saved. If your employer doesn’t offer a 401K or company match, you should contribute as much as you can to your savings until you reach 6 months of expenses saved before you begin investing.
Once you have 6 months of expenses saved, I would still recommend contributing to your savings until you’ve reached 1 year of expenses saved, but you can start allocating some money elsewhere. You have two options. Make larger payments on your debt, or start investing more. The best way to decide where your money should go is to look at your interest rates. If you are young and starting to invest, you will most likely be heavily investing in stocks, so you can expect to receive the average return on the stock market of 10% annually. Now compare the return of 10% that you can expect from investing to the interest rates on your debt. If your debt interest rates are well below 10%, which they probably are, you should keep making your minimum debt payments and start investing any extra money you have. If you have expensive debt, like credit card debt, I would first look at refinancing with a personal loan (more on that here), and if you aren’t going to do that, allocate everything to paying off any high-interest debt before investing.
Another reason to pay down debt before investing is because your debt to income ratio is high. Having a manageable DTI is a key component of financial stability. Again, debt is a financial obligation. If you have a lot of debt obligations, the likelihood of you being able to pay them if you experience financial difficulties decreases. Having a high DTI means that you’re more at risk for not being able to make your payments. If you want to buy a house or take out a loan for another reason, the bank will evaluate your DTI ratio to decide whether or not they should lend to you. You can learn how to calculate your DTI in this post. If you find out that your DTI is high, you should increase your debt payments to reduce your debt to a more manageable level before investing.
If you have a healthy DTI and no expensive debt, you can start investing! Making the transition to investing as soon as you can is extremely important because of compound interest. Compound interest will grow your money exponentially over time, literally. The earlier you start investing, the longer you have to take advantage of compound interest, which means more money in the future.
When it comes to investment options, the possibilities are endless, which is exciting and also daunting. Retirement accounts are one of the easiest tools to use starting out. If you’re contributing to your 401K, you can increase your contributions, or you can open an IRA. If you’re at this step and you’re not sure where to invest, you can learn about the pros and cons of each type of retirement account in this post. You can also invest in ETFs and index funds outside of retirement accounts. In either case, managing risk and building a diversified portfolio are essential when setting up your long-term investing strategy. It is fun to think about investing big in your favorite companies, but long-term investing is all about diversification, which means you’ll usually end up investing in a lot of boring things. Our post on how to build a diversified portfolio and manage risk will help you understand why this is important to the success of your portfolio and help you set up your investments.
If you’ve gotten through all this and still think these steps are confusing, don’t worry. Below is a decision tree that will help you through each step of this process. Each decision point in the process is marked with a diamond shape and contains a question. Start at the top and answer the question and follow the corresponding arrow to see what you need to do next. You may come to another decision point, or a circle. When you reach a circle, complete that step, and go back to the previous decision point and answer the question again. Continue following the decision tree until you reach the star.
Following this process will take the guesswork and anxiety out of managing your finances. It will set you up with a good foundation for financial stability, and get you moving toward investing and building wealth. You no longer need to feel paralyzed by the choices you’re making, or not making, about your finances, and by using this guide you can confidently take control of your money and become a rich bitch!