These days, being in debt is almost considered normal. The average adult has non-mortgage debts of several thousand dollars, and pays interest rates well in excess of 18% on what they owe. While the miracle of compound returns can be a fantastic thing when you're saving, it works in reverse when you're borrowing, which explains why debts often spiral out of control.
Credit cards are a major culprit here. While it's useful for borrowing money, if your card has a high interest rate and you can't afford to pay off much each month, then the credit card company is getting the benefit of compound returns – and who wants that?
Savings vs. debt: the knockout round
A common mistake for well-meaning but misguided savers is to carry debt on the credit card while accumulating savings in the bank. Sure, these are good intentions, but bad maths: with savings earning, say, 5%, but debts costing 18%, there's a shortfall of 13%. It makes far better sense to use the savings to pay off the debt and start again from scratch with savings that are earning real returns.
Beware the lifelong debt!
It's impossible to overemphasise the dangers of debt. Even small, seemingly harmless debts can quickly grow out of control. Take a credit card debt of $1,500. If you're charged 1.5% a month and only ever pay the minimum monthly requirement of 2% of your outstanding balance, this bill will take an astounding 37 years to clear, and at the cost of thousands of dollars of interest!
In almost every scenario, there is no better use for your first freed-up dollars than paying off high-priced debt, which, for most, means credit card debt. We'll prove it.
Consider the difference between setting aside $200 a month and coming up $200 short and covering it with a credit card. After five years of that — assuming you simply stuff your $10s and $20s into a shoe box, your credit card charges 18% interest, and you pay a minimum $15 a month toward the balance — here's where you'd be:
| Years | $200 in Monthly Savings Amounts to … | Putting $200 per Month on a Credit Card Amounts to … |
| 1 | $2,400 | ($2,652) |
| 2 | $4,800 | ($5,583) |
| 3 | $7,200 | ($9,088) |
| 4 | $9,600 | ($13,278) |
| 5 | $12,000 | ($18,288) |
Stashing your cash in a savings account earning nearly 20 times less in interest than you're paying on those lingering credit card balances leaves you $6,288 in the hole after five years, and you've paid nearly $7,000 in cumulative interest charges alone.
The bottom line: If you have credit card debt, invest in its destruction. Only once this is done can you really start building up your finances for the future.
Amass a cash cushion. Stuff happens — stuff that requires money to fix, such as a job loss, car transmission issues, and a really bad haircut before your high-school reunion. If you don't have the money on hand, you'll have to make a crash financial landing, which could mean patching over the problem with a credit card.
Your emergency fund needs to be readily accessible in a simple savings account. Don't expect to make a killing on this investment. The interest you can get on most savings accounts won't even keep up with inflation.
How big should this essential investment be? Here are some basic guidelines:
| If you … | Then your emergency fund should cover living expenses for … |
| Have no dependants relying on your income | 3 to 6 months |
| Are the sole breadwinner or work in an unstable industry | 6 to 12 months |
| Are retired and living on a fixed income | 5 years |
Sweat the big stuff and the 80/20 rule
One other thing we want to make clear: Not every "investment" has a dollars-and-cents return. Or, in more practical terms: Go ahead and enjoy your daily latte or cappuccino. At The Motley Fool, we're hardly advocates of excruciating denial and extreme penny-pinching in the name of "investing."
We'd much rather you spend your energy on the big stuff that really pays off — the 20% of line items on your budget that counts for 80% or more of your spending — things like your mortgage, cars, travel, energy, communications, insurance, and any four-figure line items in your budget.
Pinpoint your 20%, and earmark a few hours to cut those costs. Then take that savings and put it to work in bona-fide investments — in the traditional sense, that is.
Not coincidentally, making those first share market investments is the topic of the next step.
