On September 27th I spoke at the FDIC about the basics of investing. Do you know what the real foundation of investing is? It has nothing to do with stocks, bonds or mutual funds. It has everything to do with emergency funds. Before you even think about investing, you need to get out of debt and create an emergency fund so you won't go back into debt. With the solid foundation of being debt-free and having an adequate emergency fund, then, and only then, can you invest.
Why Not Pay Off Debt?
Well, let's say you start throwing your money toward paying off debt, totally neglecting the creation of an emergency fund. No sooner do you pay off some of your debt and you'll need new tires for the car. Without an emergency fund, you'll need to go back into debt to pay for the new tires. So...how does that work for you?
How Do I Know When My Emergency Fund Is Adequate?
Start with about $1,500; that is a good base. Then add to it gradually until you get to the number of months' expenses it would take for you to find a job if you lost your current one. If you don't currently have a job, and you don't have an emergency fund, now's the time I bet you wish you had one, or both.
Remember, your emergency fund needs to be invested in a liquid account, either in a savings account or a money market account, where you can get to it right now.
Are New Shoes An Emergency?
Only if you're being chased by the fashion police or your best shoes have holes in them. Sure, you really think you need that new pair of shoes, but when a real emergency comes along, you won't have the funds to cover your expenses because you gave some of your emergency fund to Prada.
Real emergencies are things like car repairs (you can't get to work or the grocery store without your car), home repairs (it's kinda hard to sleep under a roof that leaks), and co-pays at the doctor when your son comes down with the flu.
If you needed a new transmission this afternoon, could you pay for it by using your debit card, or would you have to use your credit card and end up paying 18% interest?