Part 2 - Financial Health

If you missed Part 1 of this series on Investing for Young Adults, you may want to check it out before you read Part 2. I would greatly appreciate any comments, suggestions, criticisms, or questions that you may have. Please post in the comments or use the contact form to get in touch with me. Thanks!

For our second lesson, we're going to cover general financial health. I think we all know a lot of people who live a lifestyle that they can't afford, and these types of people are often asking me how to get started with investing. I always start by telling them to examine their general financial health.

Imagine personal finance as a pyramid. Investing is not the bottom level of the pyramid. I know it's not always fun to hear, but you shouldn't necessarily jump right into investing for the future. There are some more foundational things that you need to make sure you have right first. These things aren't necessarily fun, but they are absolutely vital. I'll try and cover them broadly so you have a sense of where you should focus your attention.

Keep as Much as You Can
The first thing I want to emphasize is that building wealth is not just about how much you make, it's also about how much you keep. The person who makes $30k per year and spends $28k is building wealth faster than someone who makes $300k and spends $299k. The focus of this post will be to help you build a solid foundation that will help you keep more dollars each month and reduce your overall financial stress.

Maximize Your Income
Even though how much you make isn't everything, it's obviously still an important piece of the puzzle. Especially when you're young, you should focus on maximizing your earning potential. Why do I say especially when you're young? Well, as we saw in Part 1, the longer a dollar is invested, the more it will earn for you, with the really spectacular earnings coming in the later years. By increasing your earnings early in your career, you can front-load your investments with a decent chunk of cash and end up with far more in the long run, even if you end up making the same amount of total money over the course of your career.

Live Below Your Means
The foundation of all wealth-building is this: spend less than you earn and invest the difference wisely. It is impossible to increase your net worth and provide for the future if you spend everything you make, or more.

Many young people scrape through college, eating Ramen noodles and spaghetti, and then land a good job soon after graduation. For the first time, they're making decent money. They begin to look around at all the things they can do with that money, instead of being conservative and looking at what they actually need and building a game plan. Pretty soon, they're spending everything they're making, or more. When they get raises, they bump their lifestyle up a little bit more to match. This may be you. If so, don't despair.

It's tough reducing your lifestyle, but it's absolutely vital that you get your spending below your income in order to build wealth.

Budget
If the financial goals that you wrote down yesterday are the stops on your financial journey, a budget is like GPS, showing you exactly where you are and giving you turn-by-turn directions to get to the next goal on your financial road map. Living by a budget is absolutely critical to building wealth and you'll find it almost impossible to manage your finances with any degree of clarity and precision without one. It's so important that we'll be dedicating an entire lesson to the subject. For now, all you need to know is that if you don't have a budget, you need one.

Build an Emergency Fund
You need to have an emergency fund, for when your car breaks down, you need to fly home for a funeral, you need to cover an insurance deductible, you lose your job, etc. Many financial experts recommend 3 - 6 months of expenses, which is great, but that takes time. If you're trying to reduce debt, I recommend Dave Ramsey's plan:

1. Put aside $1000 for a baby emergency fund
2. Pay off your debts (using the debt snowball method, which we'll discuss below)
3. Increase your emergency fund to 3 - 6 months of expenses
4. Start investing*

* There is at least one circumstance in which you'll want to invest before you have eliminated all debt and have a fully-funded emergency fund: the 401k match. We'll cover that in a later lesson.

Two additional comments about the emergency fund:

1. The amount (3 - 6 months) depends on your particular financial situation. If you have two household incomes and they're both very stable, you may only need 3 months. If you're dependent on one income, have variable income, and/or expect difficulty in finding another job if you needed to, you may want 6 months. If you're a freelancer or preparing to make a big career move, you may want even more than 6 months in your emergency fund.
2. Don't leave that cash in a checking account where it will be easily accessible and earn very little interest, if any. I highly recommend opening an online savings account that pays a high rate of interest and stashing it there. Both HSBC and ING Direct are paying over 5% on their online savings accounts right now, with no fees and no account minimums. Opening an account online takes just a few minutes.

Eliminate Consumer Debt
If you remember nothing else from this entire series, remember this: consumer debt is financial cancer. Consumer debt includes credit cards, payday loans, auto loans, and basically any debt used to finance anything other than an investment. It may seem innocent enough to finance that new car for just $300 / month, but when you go into debt, you're betting your future. The borrower is slave to the lender. If you can't afford to pay cash, don't buy it. This is a simple rule to grasp, but very difficult to follow, especially in our current frenzy of consumerism.

If you are already in debt, I cannot recommend highly enough that you pay off all your debt before starting to invest (with a few exceptions). It won't be much fun or very exciting, but it's very important. One exception may be debt with an interest rate of below 6% or so, such as a mortgage, student loans, etc.

If you're paying 19% on a credit card and investing your money at 10%, you're losing money each month in spite of your investments. You're better off plowing as much money into your debts as possible to get rid of them ASAP. The recommended method to eliminate debts is called the debt snowball method and there are two variations: by order of highest balance and by order of highest interest rate. Here's how it works:

1. Decide how much extra you can put towards your debts each month, even if it's only $50.
2. Arrange your debts either from highest interest rate to lowest, or from smallest outstanding balance to largest balance (more on this later)
3. Using that extra cash you have each month, pay off the first debt as fast as possible, whether it's your highest interest or your lowest outstanding balance.
4. Take the extra cash and whatever cash you used to pay each month on that first loan and attack the next debt on your list.
5. Repeat until all debts are paid off.
6. Commit to never going into debt again.

As to whether to pay off in order from highest interest rate or lowest balance, there's a lot of debate out there. Basically, highest interest rate first is the mathematically correct way to go, because you end up paying less interest over the life of all your debts. However, there's a psychological benefit to paying off a debt, and you'll usually get to that first milestone faster by paying off the smallest debt first, making it less likely that you'll give up before eliminating all your debt. Everyone's situation is different. The important thing is to pick a method and devise a gameplan for eliminating all your debt and then stick with it until all the debts are gone and never become a slave to debt again.

Automatic Investment
Once you get to the point where it makes sense for you to start investing, it's a good idea to setup an automatic investment process to transfer money into your investments without any action on your part so that you never even see the money you're putting aside each month.

You don't need to worry about this too much right now, as we'll talk about specific ways that you can accomplish this in a later post. I just wanted to mention it here because disciplined investing on a regular basis is a basic financial habit that will reap tremendous rewards in the long run and put your far ahead of your peers.

Task: Find someone to keep you accountable
The first task from Part 1 wasn't too difficult and this one hopefully won't be either. You need to find someone to keep you accountable as you try and improve your financial health. Don't travel this road alone if you can help it.

In many cultures debt was (and still is) something to be ashamed of. Not anymore, at least in America. If you follow this plan, everywhere you look, there will be people your age living a better lifestyle than you, at least for the next few years. Most of them are probably financing that lifestyle with credit and it will catch up with them someday. Don't worry about keeping up with them. They'll find out soon enough that the years they wasted spending money recklessly can never be recovered.

The best way to ensure that you don't get caught up in the frenzy is to find someone else who shares your convictions and keep each other motivated. If you're married, this could be your spouse, but I recommend finding someone outside your marriage who can keep you accountable. When it comes to spending money that you don't have for something you want to do, such as a vacation, your spouse will often have the same motivation as you and may not kick your butt as much as a friend will.

Either way, find someone and commit together that you'll keep each other accountable for maintaining good financial health. Don't go it alone.

Don't forget to check back on Friday for Part 3: Budgeting.

Disclaimer: I am not a professional financial adviser. All information herein is provided in good faith. It is not intended to be, and should not be relied on as, a substitute for independent legal, financial, tax or other professional advice. Readers should seek appropriate legal, taxation, accounting, investment or other expertise in their local and overseas jurisdictions.