Should you start investing?   1 comment

Last time I went over why I decided to invest: it’ll help me reach FI faster, and risk is unavoidable even if I don’t invest. Now I should probably clarify – the risk of rampant inflation isn’t the same as the risk of a loss in the stock market. But remember the rule of 72. By investing, your money just earns more money (and can earn more money in a year than you can!) The risk I take is worth the reward.

But should you actually get started? Well, it depends. Over on the Bogleheads forum (a great resource that I will bring up again later), they ask that if you ask a question about your portfolio, you list how much debt and emergency funds you have (among other things). If you don’t have any emergency funds, and/or you have high interest rate debt, you shouldn’t be investing. And if you have low interest rate debt, it depends. But if none of these situations apply to you, then yes. Definitely. Even if you’re young like me and you think your retirement is a long ways off. You have the best asset available to you right now that older people don’t—time. Time to let that rule of 72 take hold.

I’ll be going over some good practices with respect to emergency funds, and also if you should invest if you have debt. And finally, how a loan might affect your credit score.

Emergency funds

An emergency fund is one of the first steps towards financial independence. By having a rainy day fund, you free yourself from having to take on high interest credit card debt when you lose your job or have a large unexpected expense. Your emergency fund should not be invested, as you want all of that money to be there when you need it.

There’s no hard and fast rule on how big your emergency fund should be. Lots of people agree on 6-12 months of expenses. At the end of the day, whatever amount you decide on, it should be enough that it lets you sleep well at night.

For some frame of reference, I’ll describe the reasoning behind my emergency fund:

I looked up my out of pocket maximum for my health insurance plan, and included that as part of my emergency fund ($3750). I then decided arbitrarily that $3000 would be enough for any other emergencies, so I settled on $6750 in my savings account. I also keep an additional $450 in my checking account (again, an arbitrary choice), and $100 in cash (not all in my wallet), which puts the grand total at $7300. Now this isn’t 6-12 months expenses calculated in a “normal way” because my rent is paid 3 times a year (on campus housing at my university) and I save up for my housing payments separately. But this is enough for 6-12 months expenses when I’m excluding housing payments. I personally don’t think my risk of losing my job as a graduate research assistant is high enough for me to worry about, so I’m fine with this amount. And if I really really needed to, I could dip into my investments.

You should store your emergency fund in a savings account. Preferably an online account, such as with Ally Bank, to get the best interest rates. Currently, Ally is offering 0.99%, which sounds terrible (at that rate, by the rule of 72, I’d probably die before my emergency fund doubles), but it is actually among the best interest rates right now. Also, while you should seek to earn some interest on your emergency fund, simply because it is possible to do so without any risk in a FDIC insured bank account, the objective of your emergency fund isn’t to save money. It’s to help you weather emergencies and sleep well at night.

I’ll have a post later on what bank accounts I recommend, but for now, I’ll just tell you this – you can easily transfer money in and out of Ally’s accounts when you need it. Or, there are some ways to spend it directly.

High Interest Rate Debt

If you have high interest rate debt, you should definitely pay that down before investing at all. Paying down debt can be thought of as investing at the interest rate of the debt (because you’re preventing yourself from having to pay the accumulated interest later).

But what interest rates qualify as high? The general consensus is somewhere in the 0-3% is considered a low interest rate (I think some people consider 4% as still low), and above that is high. But it all depends on your inclination to take risk.

Mathematically speaking, at first glance, even for a 6.8% loan one should only make minimum payments and invest the rest. The stock market returns, on average, somewhere around 8-9% a year. If this is greater than the loan interest rate, you would be making money by investing while paying off the loan. However, I don’t recommend this for a couple reasons:

  • The stock market can be quite volatile. There is the risk that while you are trying to realize the long term average of 8-9% returns, you watch your stock investments drop by 50% or more. However, that 6.8% return you get by paying down your loan is guaranteed. There is no investment that I am aware of that will guarantee you a return of 6.8% today.
  • You will owe taxes on some of the gains from your investments, whereas the return from paying down your loan is tax free
  • A loan will decrease your available cash flow, as part of your income has to be directed towards your debt
  • There is the psychological factor to consider. For some, carrying a mortgage or student loan is not a heavy burden as they don’t view it as “bad” debt. But others just don’t like holding any debt.

Low Interest Rate Debt

So what about low interest rate debt? Well, again, at first glance, you should only make the minimum payments and start investing. And it will probably make sense. But there may be other factors to consider.

A couple years ago, one of my friends had the cash to buy a car without a loan, but she got a car loan at 0% interest. Zero percent interest! At that rate, you’re making money in real terms because of inflation! Sounds like a great deal right?

The math still probably works out in her favor, but there is still at least one consideration to make. When she bought the car with a loan, Nissan said that she had to get comprehensive and collision coverage as part of her car insurance (and of course, she has to have liability insurance, as mandated by law).  Now if she didn’t intend to get comprehensive or collision coverage if she didn’t take out the loan, then that’s an extra cost (and I’ll talk about my opinion on insurance in a future post). If this is the case, then this has to be considered,

I’m sure there exist other situations where there are other incurred costs from low interest rate debt. It just all depends on the numbers. But it shouldn’t be too complicated to calculate.

For me, I think somewhere around 2-3% interest, with no other incurred costs, would probably be a low enough interest rate for me to direct my savings towards investing as opposed to paying down the loan faster. It all depends on your inclination to take risk though.

Your loan and its effect on your credit score

One of my friends was advised to only make the minimum payments to her student loans, despite being able to afford to pay them off right now, because it will help her credit score. Now, I’m not saying that’s wrong. In fact, that shoudl be correct. The credit agencies don’t reveal the exact formula for calculating your credit score, but they do tell you the criteria they use, and the weight of each criterion. One of the criteria is the different types of loan accounts you have on your credit report – credit cards, retail accounts, installment loans (such as student loans), finance company accounts, and mortgage loans. Having a diverse set of loan accounts is better.

So I did some digging to see what actually happens to your credit score when you pay off a loan. Unfortunately, I got some conflicting answers. Some people said their score went down. Some said it stayed the same. And others said it went up! So it’s hard to say. And also complicating things, it wasn’t clear if they were referring to their true FICO credit score, or an estimate of their score as provided by Credit Karma or other such sites (and these estimates can be quite off. Credit Karma estimates my score at 674, when Barclaycard (issuer of two of my credit cards) tells me my true credit score is 718. For reference, your credit score ranges from 300 to 850.).  And like I said, the credit reporting agencies aren’t exactly forthcoming with this information, so I’m not sure what “should” happen.

But what I do know is this:

  • Building a credit score by continuing to make minimum payments when she can afford to pay more than the minimum is costly because of the interest
  • Building a credit score by properly using a no annual fee credit card (ie, paying off the balance in full every month) is free

Now I’ve gone a bit crazy with the credit card applications recently. Before August of last year, I only had two credit cards. And now I have eight. And when this comes up in conversation, people ask (among other things) aren’t you trashing your credit score? And you said you’re planning on cancelling a couple cards in a year, won’t that hurt your credit score?

Regardless of how my credit score changes because of how I apply for and cancel my credit cards, what I do know is this: I have no plans to get a loan in the near future: no car loan (already have a car) and no mortgage (nowhere near ready to own a home at this point in my life). The only thing I need my credit score for is to get more credit cards. So if in fact my credit score does drop because I’ve applied for too many credit cards, or I cancel them in the future, it’s a self limiting problem—I’ll just stop getting approved for more credit cards.

Some people stress out a lot over their credit score when in fact they have no need to use their credit score in the near future. There’s no need to stress if that’s the case!

Of course, there is the possibility that she will unexpectedly need a loan in the near future. But that is merely a possibility—one with a low risk, and not one with a high marginal cost. What is guaranteed is that she will pay have to make interest payments if she holds on to her loans.

So with that perspective in mind, I asked her if she plans on getting a loan in the near future. And she said no. So I advised her that she should just pay off her loans.

Now granted, she decided to look into refinancing her loans first. Having no loans myself, I know very little about refinancing loans. And like I said above, it can make sense, depending on the interest rate. But holding onto a loan that you can afford to pay at a faster rate than minimum payments just for the sake of improving your credit score isn’t wise.

 

That post was much longer than expected. I’ll try to keep them shorter next time, even if it means breaking a long post into parts.

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Posted January 7, 2015 by Fiby in Uncategorized

One response to “Should you start investing?

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  1. Pingback: Investment Vehicles | Financial independence by 40

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