etting out of debt is the first step to achieving stability. Now it’s time to focus saving and investing so you can reach your other financial goals.
Question: Last year, I finished a debt management plan to pay off credit card debt that I’ve been amassing since college. Now I’m about to make the last payment to pay off my student loans. I’m finally in a position where I can start saving, but I don’t really know where to start.
The rate on my savings account sucks, so I know I need to start investing. But do I need to build savings first and if so, how much?
— Paula in North Carolina
Howard Dvorkin, CPA explains the right way to decide between saving or investing
First off, Paula, congratulations on getting out of debt. That’s a huge accomplishment and one you may have thought you’d never achieve. The choice you need to make now isn’t either/or because you need to do both. Here’s my recommendation on how to do things in the right order:
Start by establishing an emergency fund
Investing may be where your money will grow and really start to work for you, but first, you need a financial safety net. A right-sized emergency fund is what’s going to keep you from falling back into debt, so it’s the most critical thing right now.
A good emergency fund covers 3-6 months of budgeted expenses. That means you have enough money in savings to pay all your bills and necessary expenses for up to half a year with savings. This will cover any emergency you might have and even get you through a period of unemployment without need to run up new debt on credit cards.
For example, if your bills and other necessary expenses total up to $3,500 per month, then at a minimum, you’d want $10,500. Eventually, you’d want to get $21,000 just to make sure you’re secure in case something happens.
Don’t wait to start putting money away for retirement, especially if you have a 401k match
Another step that you want is to enroll in your company’s 401k plan if they offer one. Many companies offer a match plan, which means they give you extra money for saving money yourself. A common match plan will give you 50 cents for every dollar you save up to 8% of your annual salary.
So, make sure to enroll if you’re not already and at least contribute up to the match limit that your company offers. You can set this up with your HR department. If you have questions, your company should have a 401k plan advisor that HR can put you in touch with.
A 401k will take money out of your paychecks, which will reduce your take-home income. That’s why you want to take this step quickly, so you don’t find other uses for that money first.
If you don’t have a 401k plan through your employer, set up a Roth IRA. You’ll need to divert some of your take-home income to make contributions but saving for retirement can’t wait. The sooner you start, the less likely it is that you’ll need to keep working during your retirement years.
While your building your emergency fund, shop around for a better savings account
You’re right that interest rates on most savings accounts are pretty dismal. I’m guessing your account may have a rate that’s less than 0.1%, which is never going to get you anywhere.
The good news is that there are better savings accounts out there. With our current strong economy, you can even find basic savings accounts that offer rates up to 2%.
Many of these accounts have minimum deposits and balance amounts you need to maintain. However, now that you’re not living paycheck-to-paycheck, it should be easier to meet those requirements. So, start shopping around.
I also recommend that you look into Money Market Accounts (MMAs). These are variable-rate savings accounts that offer tiered interest rates. What that means is that the more money you save in the account, the higher your rate of return.
And you don’t need to choose between the two. You can have a traditional savings account with a lower, but still decent rate where you keep a short-term emergency cash fund – anywhere from $1,000-$5,000 to cover most regular emergencies. Then you have the MMA with your full emergency fund.
With emergencies and retirement covered, you can start investing
Once you have short-term needs covered with an emergency fund and long-term needs covered with a retirement account, you can start developing your investment strategy.
I recommend that you find a fiduciary financial advisor. Fiduciary means that the advisor must make investment recommendations based on what’s in your best interest, instead of what makes them the most commission.
The advisor will be able to help you understand which investments to choose based on your situation and risk tolerance. That’s basically an evaluation of how much risk you should be willing to take based on your situation. That includes factors like your age and other financial goals.
Working with an advisor will help you start investing in stocks without you needing to become an expert in the stock market first. They can also help you choose the right mutual funds for your retirement accounts, without you needing to be an expert in choosing mutual funds.
I still encourage you to take time to learn about investments, stocks and mutual funds, so you can work with your advisor to make informed choices. However, you shouldn’t wait to become an expert. An advisor will help you get started now.
Make sure you’re saving money for other long-term goals
Even after you generate a 6-month emergency fund, it doesn’t mean that you should just go all-in on investing with no focus on saving. You should also save to achieve short, mid, and long-term financial goals.
You should be saving money to take vacations without running up new credit card debt. You should save for major purchases. You can even consider saving to do things like buying a car cash-only. The more financial planning you do in advance of purchases, the less likely you’ll be to run into debt problems down the road.
You should also consider saving for any long-term goal you may have besides retirement. Do you plan on getting married? If so, save for it. Do you have kids? If so, they need a college fund. If you don’t have kids yet, but you plan to, save up for that, too, because each one will cost almost a quarter of a million dollars.
How much should you be saving each month? As much as possible.
In normal circumstances, you want to save at least 5-10% of your take-home income. But in this case, Paula, when you’re right out of debt and just starting to save, you should save as much as possible.
Set a budget to determine how much money you have available to save. Then make that a set expense in your budget. It’s like a bill that you pay yourself. If possible, set up a recurring transfer from your checking to savings accounts to make saving money automatic.
You may also be able to ask your HR department to split your paychecks. They can send part of your pay to a savings account and part to checking.
I hope this advice helps you, Paula. Good luck and let us know if you have any other questions.
If you need to get out of debt so you can start saving, we can help you find solutions.
Published by Debt.com, LLC