The first step in our investment hierarchy is creating cash flow. This means paying down high interest debt and creating positive cash flow so that way we can have money to invest. There are a couple other stages of cash flow that we will go over to ensure you are starting off your investment journey on the right foot.
Step 1: Establish an Emergency Fund
The first step to take is to establish an emergency fund. This helps provide a cushion for any form of emergency. It can include job loss, medical emergency, household repairs or even another pandemic. No matter what, you should have some cash on hand to help you whether the storm when need be. Emergency funds also come in stages, growing larger as your life changes and you become more risk adverse. Below are the stages I took with my emergency fund.
The First $1,000.00
Having $1,000 saved up for a rainy day should be your first step. This can cover things like unexpected bills, car repairs and short term cash flow needs. The difference between having an extra thousand dollars and not is often the differentiator between catastrophe and an inconvenience. This should be your top priority for your cash to ensure that you don’t just keep digging yourself deeper into a pit when short term emergencies pop up.
Three Months of Expenses
The second step of building your emergency fund would be establishing three months worth of expenses. This is to prepare for larger emergencies. Just recently we have gone through a pandemic in which millions of people found themselves suddenly without jobs. Having three months worth of expenses to weather the storm can be a great way to sleep easy at night. It is also important that this is three months worth of expenses not income. If we lost our job than we are in survival mode, it is time to cut out any unnecessary expenses.
Future Emergency Fund Growth
The last and final step of growing your emergency fund includes building it beyond the first three months with your excess cash flow. Some people stop at six months worth of expenses, others go all the way to a year. It really depends on your comfort level. The other thing that you can do at this level is begin keeping your fund in near cash equivalents. This includes things like treasury bonds, municipal bonds or certificate of deposits that are easily liquated but still work for you more than a savings account would. The other thing to consider at this point is tapping into places like your home equity for longer term emergencies. Home equity line of credits can be a real a lifesaver for expenses that go beyond your normal six months.
Step 2: Use Cash Flow to Pay Down High Interest Debt
The second step on the first layer of the investment hierarchy is to pay down high interest debt. I agree with Listen Money Matters that you should first be paying off any debt over 10% before you invest. I would start paying off this debt as soon as you have your three months of an emergency fund set up.
There are two different major debt payoff strategies. If you are interested in learning more about them check out this post on the debt snowball vs debt avalanche. The goal is to get all of our high interest debt paid off as quickly as possible. As we continue paying off debt this will also increase our cash flow. With increased cash flow we can put more money towards our debt and make sure we get it out of the way as quick as possible.
Paying off Debt below 10% with Cash Flow
After we get our high interest debt paid off the next step would be paying off other debts, things like car loans, student loans or mortgages. This gives us the same benefit of increasing our cash flow so we have more money to invest into our future. However, not all debt was created equally. The most common term for mortgages is 30 years and that is a long time to wait to invest. Historically, the market returns roughly 10% year over year during a long enough time before inflation. If we have a mortgage at 4% than we are actually making 6% each year by investing instead of paying off our mortgage. Not only that, the compounding interest will also increase how much is growing each consecutive year.
Let’s use a real world example. Let’s say you have an extra $500 a month that you can either put towards your mortgage or invest that money. You just took out a 30 year mortgage for $200,000 that has an interest rate of 4.00%. This results in a principal and interest payment of $954.83. Our first option is to put the $500 towards the mortgage. This will get the loan paid off 14 years and 7 months instead of the original 30. After that we can start investing the total of $1454.83.
The biggest difference between these two plans is the end results. To give a fair assessments I tried to do the math going out for a few different time frames. This are also assuming a 10% annual return every year which isn’t exactly realistic to have consistently. However, after 30 years you’ll have your mortgage paid off for both strategies. With investing the extra $500 you’ll have $1,130,243.96. If you pay off your mortgage first than you’ll have $814,555.17. As we go further in the future we see an even larger difference. At 40 years it is an even bigger difference with $3,357,631.92 vs $2,503,049.25 respectively.
Step 3: Identify Excess Cash Flow
The last step before we begin investing is identifying our time frame for our excess cash flow. If you are saving up to buy a house, it is probably better than you stick your excess cash flow somewhere liquid for the short term goal. If this is money that you won’t need for more than 10 years, then it is probably better to invest your money. All your excess cash flow does not need to go to the same spot either. If you have a surplus of $750 a month, you could set aside $500 towards your short term goals and $250 towards your long term goals. Either way, it is important to move your money with purpose and goals in mind.
Step 4: Move Up the Pyramid
Now that we have identified what steps to take with our cash flow, it is time to move up the pyramid to our employer sponsored retirement plans. This is after we have established our emergency funds, paid off high interest debts, and assigned goals to our excess cash. Do you have any other steps you take with your excess cash flow? Let me know in the comments below!
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