You may remember from your elementary school math class the term:
"PEMDAS: Parentheses, Exponents, Multiplication, Division, Addition, Subtraction". PEMDAS is the order of operations in mathematics. You cannot Add or Subtract before you Multiply and Divide. Well, we also have a PEMDAS order of operations in finance.
Too often I see people saving money into their 401(k), Roth IRA, or brokerage account while still holding a balance on a credit card. These investment accounts do not provide guaranteed returns, while paying off debt always provides guaranteed returns. The stock market has historically returned 8%-10% per year on average, but the average credit card interest rate in America today is 24.80%. To avoid falling into the trap of earning 10% in the stock market and paying -25% on a credit card (a net -15% return), follow these 4 steps BEFORE you start investing:
Step 1) Protect yourself. Build up an emergency fund of 3-months of expenses.
Calculate how much you spend on average each month. Once you know how much you normally spend each month, multiply that number by x3. Your first goal is to set aside that much money into a high-yield savings account. Do this before you start paying off debt or investing. The goal of this emergency fund is to prevent you from getting further into debt if an emergency arises in the future.
Step 2) Employer Match. Contribute to your 401(k) up to the employer match.
Once you have a small emergency fund established, you will want to contribute to your 401(k) up to the employer match. If you don't contribute to your 401(k) at all, you will miss out on the money your employer is willing to give you for your retirement. These matching programs are essentially an instant 100% return on investment that you should take advantage of.
Step 3) Debt. Pay off high-interest debt (debt with interest rates of 5% or above).
Once you have a small emergency fund established and you are contributing to your 401(k) up to your employer match amount, then you will want to start paying off your high-interest debt. I consider all debt with an interest rate of 5% or above as "high-interest". You will want to get rid of all of it before you start investing. There are a number of strategies to paying off your debt, but I suggest either the "Snowball" or the "Avalanche" strategies.
The "Snowball" method is where you write out all of your debts and order them from smallest-balance to largest-balance. Then you start paying down your smallest sized account first and work your way up to your final largest account. This is usually the easiest strategy to follow because you can see the progress of closing out multiple debt accounts quickly.
The "Avalanche" method is where you write out all of your debts and order them from highest-interest to lowest-interest. Then you start paying down the highest-interest debt first and work your way down to your lowest-interest rate debt last, until it is all gone. This is mathematically the "best" strategy to minimize the interest that you pay on your debt, but it is harder to accomplish in comparison to the "Snowball" method.
Step 4) Additional Emergency Fund. Reinforce your emergency fund to 6-months.
Once you have paid off all of your high-interst debt (with interest rates of 5%+), then you should save an additional 3-months worth of monthly living expenses into your high-yield savings account. This should bolster your 3-month emergency fund into a 6-month emergency fund and protect you from larger emergencies like suddenly losing your job.
Save and Invest. Once you have completed these first 4 steps in the "PEMDAS" financial order of operations, you are now ready to start saving and investing. In no particular order, you may want to consider these savings goals:
Maximizing your annual Roth IRA / Backdoor Roth IRA contributions
Maximizing your annual Traditional / Roth 401(k) contributions
Saving to buy Real Estate as a first-time homebuyer or as an investment property
Paying down low-interest debt early (debt with interest rates of below 5%)
Investing excess savings into taxable brokerage accounts
Or other unique savings goals specific to you!
Working with a financial planner can help you prioritize which of these savings goals may be right for you and your specific financial situation. If you are interested in a free consultation with one of our fiduciary financial planners, please Click Here.
DISCLOSURE: Silverstone Financial LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance. Please see our disclosures page for additional information.
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