So you have debt and are wondering on whether you should invest in the stock market or pay off your debt? This might be the guide just for you.
I will give you a step-by-step guide on how to deal with the situation. By following this guide you can understand for yourself at which point are you and when can you start investing.
1. Pay off Your High Interest Debt
Here I am talking your credit card debt, possibly your auto loans, your personal loans. Basically anything that is over 5% interest needs to go and this should be your number one priority. If you are not familiar with compound interest I advice you to go and first read my Beginner’s Guide.
Now let me explain why this should be your first priority. Compound interest can be a powerful ally, but also a powerful enemy. You want it to work for you and not against you. In debt repayments it works against you. The higher the interest the faster your debt grows. It can be something like a wildfire.
Most of those fires start from a single branch of a tree, or a small bush. But some of them grow and can take out entire forests. And why does that happen? Because the fire grows exponentially, the same as the debt repayments. The more money you owe, the more interest you owe. And the more the interest grows the more the money that you owe grows, you get the point.
That is why you need to stop this wildfire in your wallet before it has taken all of your finances. At first it might start as a small payment, but once you let things go out of hand you can get screwed quickly.
Believe me, I’ve had plenty of friends who have totally destroyed their financial situation by taking out one or two quick loans. Their main mistake? Not understanding the power of compounding. Not many people take it seriously, until it goes out of hand.
After all at first it’s just a couple hundred dollars right, not a big deal? Well kind of yes, but when it goes to the thousands and the tens of thousands things start looking very real. That’s why my advice? First priority- pay off your high interest debt before thinking about doing anything else with your money.
2. Build an Emergency Fund
What is an Emergency Fund
After you cleared your high interest loan it’s time for the next step- providing yourself with a cash cushion or in other words- an emergency fund.
So what is an emergency fund? This is some cash you set aside for emergency situations. At the moment we are witnessing first hand an emergency situation with this global pandemic. For example I am a chef and the coronavirus has wiped out pretty much my entire industry.
I was also caught in the middle of things so I cannot be getting any sort of unemployment benefits at the moment. If you want to read about my story you can always do so in My Journey section.
But what does that have to do with the emergency fund? Well because of that I can survive a couple of months without being pressured by bills. I also don’t have any debt to put any extra pressure on me at the moment.
Those are exactly the kind of situations when you need to have some extra cash around. It helps you sleep better at night and not go into panic mode too quickly.
It also protects you from going into debt. It acts as a cushion before you are forced to take out a loan.
How to Build an Emergency Fund
Now when I say emergency fund that doesn’t necessarily mean cash under the mattress right? There are plenty of options. The idea is to have that money in a fairly liquid form.
Liquidity means being able to withdraw them or move them around. For example a house is not a very liquid asset, because it can take a long time to list, sell and close a deal on one.
I also don’t consider stocks a liquid asset and neither should you. They can fluctuate too much and if you need the money quickly this might be a problem.
For example the stock market recently dropped by almost 40% in less than a month. You wouldn’t be very comfortable in having to now withdraw your money when they are almost in half right? I will give you an example.
Let’s say you have set aside $3000 that you think will be enough to cover your expenses for 3 months. But what happens if all of a sudden that money is now $1500. And you need the money when you are out of the job because of the same crisis?
And stocks usually drop when you need your money the most- during crises. That’s why I advice you to keep your emergency fund out of the stock market.
What do I Consider a Liquid Asset
Well- you have savings accounts, money market funds and checking accounts. All three of them are very safe and easy to move around. You can withdraw money from all three within a day and that’s the point.
You can also leave the emergency fund in your bank account of course. But most of the time you don’t need it and it can just stay idle for years. That’s why my advice is to keep it in some form of account with at least some interest to cover for inflation.
How Much Money Should You Keep in Emergency Fund?
This depends on your individual situation, but I advice you to have at least 3 months worth of expenses in your emergency fund. That includes rent, food, bills, basic necessities- things you will need in order to survive if you have no other income.
Of course you might want to increase that if you have kids, if your job is unstable, if you have health conditions etc. Let’s say you work in a field where your pay is not a constant- for example a real estate agent. Most of the agents work mostly on commission and their industry is highly cyclical.
Cyclical means that it can have big ups and downs. For example in real estate you have big booms when the economy is doing well and then big busts when the economy is in a recession. Not many people can or want to rent or buy a home during a recession.
That leaves the agents with prolonged periods of much lower income, or no income at all. In this case it would be clever to have at least a 6 months emergency fund. Same goes for people in sales, construction, hospitality and others that can get affected much worse during a recession.
So to sum up- make sure you have at least 3 months worth of expenses in your emergency fund, but it might be a good idea to have for 6 or more depending on your personal circumstance.
3. Fund Your Retirement Account
In the UK people have the option for an ISA, I believe in the US the IRA is a similar product. There are similar tools in many countries around the world.
The idea is to fund your own investment account that will act as retirement money. The catch is that you lose some advantages if you withdraw money before a certain age or unless certain requirements are met. But in return you don’t have to pay taxes on any gains you make within this account.
If you want to check in more details about the IRA you can Click Here.
If you want to check in more details about the ISA you can Click Here.
So overall here is the point- those accounts are a great tool to grow your wealth and worry less about retirement. They protect your holdings from taxes and this will increase your returns in the long-term. Taxes can eat away a big part of your income and you are most probably familiar with this concept.
Let’s say you have a chance to work a job that doesn’t require you to pay taxes and one that does. Which one would you choose? Yeah I thought so. The principle here is similar- why pay taxes if you can protect your portfolio from that?
That’s why my advice to you is to start with first investing in a vehicle such as an IRA, ISA or whatever your country is using. Of course not every country has a program like that, but if yours have it is a good idea to use it.
What Should You Buy in an IRA/ISA
Usually those accounts are very long-term as you will use them when you are near a retirement age. That’s why ti is a better idea to pick either ETFs or high quality Dividend Stocks. The main idea is that you want to have stocks that are very stable and have steady growing earnings/dividends.
If you want more guidance on which companies to choose I have plenty of articles on that matter in my Investing section.
The point is to have your retirement account as a steady base and then you can build on top.
4. Check Your Lower Interest Debts
Here I am talking your auto loans, your mortgage, maybe a bigger personal loan. Or in other words- loans that are less than 5%, but still a toll on your personal finances.
That’s why you need to sit down, take a look and try to come out with some sort of an action plan. If you have a very low fixed rate interest rate mortgage it might not be a problem to just continue paying it off as it is. But an auto loan at 5-8% for example is better off paid as soon as possible.
Here is a very good guide on how to create your Debt Rayment Program.
And after you repay most of your loans it’s important to try and stay away from high interest ones. If you cannot buy something outright that usually means you cannot afford it. Of course things are different for a real estate or business loans, but we are talking mostly consumer loans here.
If you need to take a loan to buy a TV or a fancy car that means you don’t really need them. I have been buying a lot of things second hand, but thanks to that I don’t have any debt, which makes my life much easier. Yes, I don’t own a fancy car or a big TV, or an expensive watch, but I feel free and I don’t owe any bank a dime.
So to sum up- try and pay off as much of your debts as possible, with only leaving the mortgage payments. Then we can proceed to our next step.
5. Build Your Investment Portfolio
As you can see there are 4 steps that you need to do before you can start investing. Yes, that might seem like a lot, but that’s the proper, sustainable way to do it.
Yes, you can start investing while having a ton of debt. But that way you are only going to go around in circle. Maybe make some returns, use them to pay your interest and you are at square one again.
If you don’t have any debt your gains in the stock market are all for you and not for the banks and that should be your goal.
So now that your are ready to Start in The Stock Market there are plenty of guides available for you. My advice is to first pick your Strategy, then learn How to Build Your Portfolio and then learn How to Research Stocks.
Once you learn that you will have the basics set and can start slowly building your portfolio. Remember that investing is a long-term game so no need to rush.
6. Act Responsibly
Now that you have your own investment portfolio it is important to keep on track. If you managed to clear all your debt- congratulations! But now it is important to remember how far you’ve come and not regress to your old habits.
Once you have a bit more money in disposal it can get tempting to just go and spend them all on something you might not really need. Don’t get me wrong- not all of our purchases are things we need. But it is important to make sure you are in a decent financial situation before that.
7. Summary
Ok, now let’s sum up. I will try and sum up the whole situation with the building of a house. So in order to build a house you need to find an appropriate land, clear area and good conditions to build. Paying off your debt provides exactly that- gives you good conditions for your personal finances.
Then you need to build a strong foundation- your retirement account is just that. It provides you with a good foundation that you can build on.
After that the house is your investment portfolio. You can build it to your likings, you can use different strategies and it will be something that can stay for generations.
Then of course you need to take care of your house. Just the same way you need to take care of your portfolio. You need to rebalance it every now and again, you might need to remove some positions or add new ones. But it is the same as having a house- you might need to change a door, fix the roof and whatnot.
I hope this analogy makes it easier for you to understand the steps you will need to take. After all you cannot build a house on a rock, or without proper foundation. Or maybe you can, but I am not even sure what such a house would look like.
Well anyway, that will be all from me today, hope you now have the answer to your question on whether you should invest or pay off debt. Thank you for reading, hope you are all well and stay safe.