Not sure whether to save, pay off debt, or invest for retirement? Use this 5-step guide to make smart money decisions. It will help you leverage your financial resources, reduce stress, and build wealth as quickly as possible.
Making decisions about money can be difficult. Most people have several financial goals—but knowing which ones should come first or where to start can be challenging.
We all have limited financial resources to manage. If you don’t know what your priorities should be, it’s easy to feel stuck and never make any progress.
Here are some recent questions I received from Money Girl readers and podcast listeners:
Michele M. asks: “I’m wondering if I should use my savings to pay off my credit cards and then build my savings back up again?
Naomi S. wonders: “I’m trying to get out of credit card debt, take control of my financial life, and set up a good financial future for my children. Do you have any tips on where to start so I can have less financial stress?”
James B. asks: "With so many ways to spend and invest money, I'm not sure that I'm focusing on the right things. What should my financial goals be, exactly?"
These are questions you may have asked also. In this episode, I’ll answer them by giving you a step-by-step guide for making smart money decisions.
5-Step Guide for Making Smart Money Decisions
Whenever you have a money question or dilemma, come back to this guide for a clear path forward. It can be the ticket for leveraging your financial resources, reducing stress, and building wealth as quickly as possible.
Step #1: Build a cash reserve.
Oftentimes I get money questions about paying off different types of debt, such as credit cards, student loans, and mortgages. My first response is to ask if you have a cash reserve, also known as an emergency fund.
Your number one financial priority before doing anything else should be to accumulate an emergency fund. Having a cash cushion to fall back on can be the difference between surviving a financial emergency—such as losing your job or having an unexpected medical bill—or getting buried under it.
Devastating events are tough enough to handle without also being stressed about money. When you don’t have a financial cushion to soften the blow of a large expense or a loss of income, you could end up going into debt.
How much emergency savings you should have is different for everyone. If you work in an unstable industry or are the sole breadwinner for a large family, you probably need a bigger financial cushion than a single person with no dependents and plenty of job opportunities.
Ideally, you should accumulate at least three to six months’ worth of your living expenses. Another good rule of thumb is to accumulate at least 10% of your annual gross income. For instance, if you earn $50,000, make a goal to accumulate and maintain a $5,000 emergency fund.
If you’re starting with zero savings, you could begin with a small goal, such as saving 1% or 2% of your income each year. Or you could start with a small target like $500 or $1,000 and increase it each year until you have a healthy amount of emergency money.
If you’re trying to accomplish other financial goals before accumulating a cash reserve, you’re putting the cart before the horse.
If you’re trying to accomplish other financial goals before accumulating a cash reserve, you’re putting the cart before the horse. Take the time to evaluate how much emergency money you have, how much you need, and create a plan to bridge the gap.
Also, I don’t recommend investing your emergency money or considering your retirement fund your cash reserve. Your emergency fund should be in a safe, high-yield, FDIC-insured savings account. Don’t worry if your cash reserves earn little or no interest in the bank. They’re not supposed to.
The purpose of emergency savings is to be accessible and liquid in the short term. If you invested it, the value could shrink to nothing the moment you desperately need it.
Being financially responsible means that you’re prepared for a day when bad luck may strike. Think of an emergency fund as an investment in yourself that ensures future financial safety and happiness.
If you’re struggling to build a cash reserve, automate the process by having a portion of your paycheck direct deposited into a savings account or transferring funds from your checking to savings.
Let's return to Michele's question about using her savings to pay off my credit cards and then building it back up again. You should always keep an ample emergency fund because you never know when you'll need it. If you have more than enough savings, then you need to use it for the following steps...