The greatest investments anyone could make have nothing to do with stocks, mutual funds, bonds, CDs, or real estate. In fact, buying any of those assets before you've taken care of the "big three" investments can be detrimental to your long-term financial success. Here's why an emergency fund, health insurance, and paying down credit card debt are the three best investments you can possibly make.
Not just for emergencies
An emergency fund is a pool of money set aside for unexpected expenses. For example, if your car's transmission dies or your roof springs a leak, that's a pretty big expense you may not have been prepared for. And if you or your spouse loses a job, you may go several months with reduced or zero income. For situations like these, it's important to have some readily accessible -- i.e., not invested -- money that you can use in a pinch.
Many experts say you should have an emergency fund equal to six months' worth of expenses, including:
- Housing payment (rent/mortgage)
- Car payment
- Student loan payments
- Credit card payments
- Any other recurring expenses you may have
When you crunch the numbers, this could add up to a substantial amount of money, so don't worry about getting there right away. Instead, start setting aside what you can afford to. If you can set aside, say, $100 per paycheck, it could grow into a substantial emergency fund before you know it.
Now, before the comments come pouring in, I know what some readers are thinking (since this is an investment-focused website). "My brokerage account can transfer money to my checking account overnight, so why do I need a separate emergency fund?"
I'm assuming that you buy your investments for a reason and don't want to sell them every time you get a flat tire or have to pay a speeding ticket. Doing so defeats the purpose of responsible and effective long-term investing, especially if you're forced to sell stocks when they're at a low.
What if something happens to you?
The most important of the three "investments" on this list is health insurance for you and your family.
The Affordable Care Act has made health insurance premiums more, well, affordable. And more importantly, it has made health insurance mandatory. Under no circumstances should you choose to pay a penalty in lieu of obtaining health insurance. Without health insurance, you're just a car accident or heart attack away from a financial disaster -- even bankruptcy.
And if you can afford it, you may want to opt for more than just a basic plan. Sure, the base-level plans will protect you from financial ruin if something catastrophic happens. However, you could still end up paying thousands of dollars out of pocket, even if you simply have some minor medical issues throughout the year.
Don't give your money away
If you owe money on high-interest credit cards, then you're giving money away hand over fist.
Let's say you have an extra $3,000 -- maybe from your tax refund -- and you have to choose between paying down your credit card debt and investing the money. We'll also say that you have $3,000 in credit card debt at 15% interest. So it's costing you $450 per year just to maintain that credit card debt, and that's if you keep a constant balance. Many credit cards, moreover, have much higher interest than 15%.
If you invest, the best returns you can reasonably hope to achieve aren't even close to the interest you're paying on the credit card. The S&P 500's historical average is about 9.5%, so if you're an "average" investor, you can expect your $3,000 to produce about $285 in returns in the typical year.
In other words, you're more likely to lose $165 per year by choosing to invest instead of paying off your credit card debt.
Of course, this is a simplified example. Investment returns vary from year to year, and credit card amortization is more complicated than the few sentences here. Still, the fact remains that it doesn't make sense to use extra money to invest while you have high-interest credit card debt hanging over your head.
Once all of this is taken care of, then it's time to invest
If you have a sufficient emergency or "rainy day" fund, have decent health insurance, and don't have high-interest credit card debt, then it makes sense to start putting your extra money into stocks, bonds, or other investments.
The point of long-term investing is to steadily grow your money for your future, and it's tough to do that if your investment returns are being eaten up by credit card payments and you need to sell assets every time you have an unforeseen expense.