4 steps to financial security
Prioritizing your financial wants and needs can be tricky, but doing so is essential for good fiscal health.
This post comes from Philip Brewer at partner blog Wise Bread.
Because everybody's circumstances are different, there's no one answer that applies to everyone. Instead, the right way to approach this problem is with a mental model -- a way to think about these issues that can guide you to coming up with the right answer for your particular circumstances.
Here's my stab at one.
First, stop the penalties
Probably the most expensive mistake you can make with your finances is to find yourself paying penalties for screw-ups. I'm talking about things like late fees, overdraft fees, disconnect/reconnect fees for utilities and penalty interest rates.
If you have any accounts that are racking up penalties, that's the first thing to take care of. All your spare money should go there. Engage in some emergency belt-tightening, if necessary, to free up cash. In this one case, it might even be worth going further into debt to cure this sort of problem. (It depends on the interest rates you have to pay. For example, interest rates on a payday loans are often so high that you're better off just paying the penalty rate on your credit card.)
Second, make things safe
You can prevent most of the worst problems with a very small emergency fund, one just big enough to smooth over glitches.
My suggestion for a minimal emergency fund is roughly the size of your biggest single bill -- maybe your rent payment or mortgage payment.
Of course, a small emergency fund like this doesn't provide much protection if there's a real emergency -- you lose your job or have a large expense not covered by insurance. Where it helps is when something goes very briefly awry.
Suppose your payment to your insurance company goes astray and you need to write a new check today or else your insurance will be canceled. The problem will be sorted out soon enough -- either the check will be permanently missing and you can just stop payment, or else it will turn up and the insurance company will refund you the overpayment. But right now you need a little money to keep your insurance from being canceled.
A small pool of available cash like that is almost immediately self-funding, that is, covered by the late/overdraft fees you've avoided.
A similar move is to stockpile some staples in your pantry. When I was younger and my finances were out of control, I'd sometimes find myself buying an expensive meal at a nice restaurant because I was out of money. (In those days, grocery stores and cheap restaurants didn't take credit cards, but expensive restaurants did.) Have enough food on hand so you can always prepare a meal.
Similarly, keep some cash on hand. Now that everyone takes debit cards, currency is starting to seem like an anachronism. But even today there are some problems best solved with actual paper money.
Third, pick up free money
Once you've got your finances free of ongoing penalties and safe from the constant danger of new ones, the next step is to pick up as much free money as possible.
Probably the biggest single source of free money for most people is an employer match for their 401k plan. (A lot of employers stopped matching 401k contributions during the financial crisis, but many have now resumed the practice.) A match of 50% or 100% on the dollar is so much money that it completely dominates any investment return; you probably don't want to make any other sort of investment until you're picking up the full match on your 401k.
Another source of free money is what you can pick up when all the aspects of your household are running smoothly.
When you've got an emergency fund that's larger than the bare minimum, you can afford to stock up when there's a good bargain at the grocery store -- free money.
When your pantry has all the staples, you can pick up whatever's fresh and cheap at the grocery store and know that you'll be able to turn it into a meal -- free money.
When you've got a bit of daylight between what you earn and what you spend, you can start paying down debt and stop paying so much interest -- free money.
When your debts are paid off and you're maxing out your 401k, you can start investing more aggressively, and hopefully earn some higher returns: free money.
Fourth, everything else
So far, the priorities for everyone have been about the same. At this point, personal factors begin to make a bigger difference.
- Is your job very secure? Then maybe you can start investing even while you're getting your emergency fund fully funded.
- Do you have any debts at high interest rates? Getting those paid off early is a priority, while long-term, fixed-rate debt (like some mortgages or student loans) can be more comfortably paid off over time.
- Do you live in a disaster-prone area? If so, expanding your pantry from the bare minimum to something that will see you through a blizzard or flood or a trucker strike might be a priority.
Your personal situation determines what's best for you. But now you have a mental model for figuring out what to do first: Stop the penalties, make things safe, then pick up free money.
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