Would you consider yourself to be a financially healthy individual? According to a report by The Center for Financial Services Innovation (CFSI), people who are truly financially healthy should be able to answer "yes" to the following three questions.
- Are you able to pay your current obligations? This includes things like your mortgage, car payment, utilities, and any other recurring expenses. If this applies to you, the solution is obvious – cutting down your expenses is the smartest way to improve your financial health.
- Are you able to cover unexpected expenses? In other words, if you got a flat tire today, would you be able to pay for it without borrowing money or using a credit card?
- Are you setting yourself up to cover future expenses such as retirement?
If you answered "no" to the second or third question, here are some steps you can take to improve your financial health.
Make sure you're covered
If you don't have health insurance through your employer, it's important to obtain adequate coverage on your own, even if it seems expensive. After all, a serious medical catastrophe like a car accident can lead to financial ruin if you're uninsured.
Now, the Affordable Care Act has made health insurance more, well, affordable -- plus you'll pay a penalty if you don't get insurance. So, while this isn't quite as big of a problem as it used to be, it's still important enough to your long-term financial health to briefly mention here.
Start building an emergency fund
According to a Federal Reserve survey, 47% of Americans couldn't cover an unexpected $400 expense without selling something or borrowing the money. If you are financially healthy, a moderate emergency expense should be little more than an inconvenience – not a reason for going into debt.
With that in mind, it's important to put money aside to cover unforeseen expenses.
The bad news in this regard is that most experts recommend that you set aside enough money in an easily accessible place to cover six months' worth of expenses. When figuring out how much to aim for, remember to include:
- Your rent or mortgage payment
- Car payment
- Credit card payments
- Student loans
- Other recurring expenses (cable, Internet, car insurance, pest control, etc.)
- Other necessary expenses like gas for your car
The point is that you may need more to get through six months than you think. Understandably, this may seem like an impossible amount to set aside.
Alternatively, the good news is that you don't need to do it all at once. Even if you can afford to set aside say, $50 out of every paycheck, it would be an excellent start. You'd have enough of an emergency fund to cover most unforeseen expenses (like a flat tire) in just a few months, and you'll improve your financial health long before you have six months' expenses set aside.
And, you can even set aside money for emergencies and invest for retirement at the same time, as I'll discuss a little later.
Pay down your "bad" debts
It's silly to think about investing while you have high-interest debts to worry about. Your mortgage and other debts like auto and student loans are OK to have, provided they're at reasonably low interest rates. However, credit card debt in particular is counterproductive to your long-term financial health.
As a simplified example, let's say you owe $5,000 at an average interest rate of 18%. So, you're paying $900 per year just for the privilege of owing money. And, instead of paying it off, let's say you decide to put $5,000 in an IRA to save for your retirement.
Now, saving for retirement is certainly an admirable goal, but consider the fact that excellent investors can only manage consistent gains of about 10-12% per year. So, even if your $5,000 IRA investment results in a 12% annual gain ($600), your still losing $300 by paying more credit card interest than your investments are earning.
Before you get serious about investing, it's important to make paying down your high-interest debts a priority. What constitutes "high interest"? Well, for our purposes I'll define high-interest as any interest rate that is more than you could reasonably expect to earn from investments. The S&P 500's historic rate of return is about 9.5%, so any debts you have with interest above this level should be top priority.
Then, start investing for the future
So, the three things I've discussed all have to do with answering the second financial health question. Once all of these are taken care of (or you've at least made progress toward them), only then should you move on to the third measure of financial health -- setting yourself up for the future.
An IRA is the best place to save for retirement, and it comes in two varieties -- traditional and Roth. Traditional IRAs are designed to give you an immediate tax break and to allow your money to grow tax-free. A Roth IRA, on the other hand, isn't tax deductible now, but your withdrawals will be tax-free once you retire.
For people still worried about emergency savings and that don't want their money tied up until they reach retirement age, I always suggest starting with a Roth IRA, for one main reason. Since you've already paid taxes on your contributions, you are allowed to withdraw that money (but not any investment gains) without penalty, and for any reason.
In other words, if you have health insurance and you've paid off your credit card debt, but are still working on an emergency fund, a Roth IRA can help you do that while investing for your future.
Once you've established a Roth IRA, read this article (and other Motley Fool content) for a primer on what stocks make great IRA investments. And, since you'll be financially healthy enough to invest, you can look forward to years of tax-free investment growth and a brighter financial future.