Financial planners and other investors love the power of compound interest.
A certain amount invested that gets a certain percent return over time will grow to “x” amount of dollars. Compound interest charts can be motivating, especially when time is on your side.
You need to walk before you can run. There are a few things that should be in place before you rush to the market to make your fortune.
The most important thing you can do with extra money is create an emergency reserve.
An emergency reserve should be between three and six months of your living expenses. Do not invest your emergency reserve; keep it in a place where you can access it with a touch of a button.
If you are married, make sure to have the emergency reserve titled in such a way that will allow both spouses to access the money in an emergency. This is usually a joint account or a trust.
Unemployment, health problems and insurance deductibles are a few of the many things that can trigger a dip into the reserve.
Having that money set aside allows you to be more confident in your future. Until you have created the emergency reserve, investing should be a lesser priority.
Another item that should take a higher priority than investing is paying off high-interest debt.
Credit cards are the most obvious pay-off priority. With interest rates that can be more than 20 percent, there is no reason to take a chance of investing.
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People who are approaching or are in retirement usually create a diversified portfolio that will generate a 4 to 7 percent return. Any debt that has an interest rate above a reasonable expected rate of return should be paid off.
Not all debt is bad. Some interest rates are low, and some allow a tax deduction. Mortgage rates have been less than 5 percent for years and allow for a tax deduction.
There are also times when money that is invested should be put into cash.
When you are saving for an important item and plan on buying that item within 12 months, those funds should not be invested.
I have seen people lose down payments for a home or funds saved to purchase an engagement ring only because the market turned so fast.
This may require you to use money market accounts or short-term bonds, which usually have a meager rate of return. This may be frustrating, but it is better than losing the needed money at a crucial time.
Over a decade ago, I decided to move some investments that I was very fond of to cash. I was getting close to buying a home and needed that down payment.
It was frustrating to see the market rise after selling. Within a year, the market crashed in the credit crisis and that cash enabled me to buy a home.
Setting cash aside can be a difficult thing to do, especially when you see others making money in the market.
Ignore greed’s siren call; feeding your family and meeting basic needs is more important.