As recent years have shown economic instability, many investors are wondering what steps to take next to further their financial goals. Should they continue to invest into the stock markets? Or, should they focus their discretionary cash flow toward paying down debts? While there is never a one size fits all answer to questions such as these, basic principles can help guide you down the right path for your given financial situation.
Your Financial Snapshot- Assess your Current Situation
Prior to determining what next steps to take, it is critical that you assess your present financial situation. Spend time reviewing your current income, expenses, assets and liabilities. What is your present net worth? Is it positive or negative? How much discretionary cash flow does your household have on a monthly or annual basis? Discretionary income refers to the amount remaining after all fixed and variable expenses are paid each month. In other words, the funds available to put toward your financial goals and objectives on a monthly or annual basis.
What are your top financial goals (college planning, retirement planning, purchasing a vacation home)? Where are you in relationship to these financial goals (i.e. what is your gap- the difference between what you have saved versus what you need saved)? Once you have taken a close look at your present situation, you can more accurately address the question of whether you should invest into the stock market or pay down debts/bills.
Interest Rates vs. Market Upside
Now that you understand where you are financially, you can begin to assess what steps you need to take to achieve your financial goals. Should you invest into the stock market in hopes of capitalizing on annual gains? Or, should you direct discretionary cash flow to pay down debts?
Over the long term, the stock market has yielded individual investors between 10-11% returns annually. However, investors experienced losses during interim years, as all funds invested in the market are subject to risk. In the event that you invest excess cash into the markets, only to lose a portion or all of those funds, you are left not only with less capital, but the debt you began with. Financial professionals suggest building a solid financial foundation prior to investing into the stock markets. A solid financial foundation includes building adequate cash reserves in the event of an emergency, obtaining the proper amounts of insurance to protect against things that you cannot afford to lose, and living and reducing consumer debts. With this in mind, despite the opportunity for upside, it is more financially prudent to invest discretionary dollars toward paying down debts.
Taking the Next Steps
Now that you understand the rationale behind focusing on your present debts, it is time to take action. During your financial assessment, you should have had the opportunity to carefully assess your debts/bills. Create a list of debts, beginning with the highest interest rates first. If possible, search for opportunities to lower your annual interest rates through either transferring balances to lower interest cards, or through the power of a debt consolidation loan. Lower interest rates will enable you to pay down debts quicker and more efficiently. When working to pay down bills/debts, you always want to place additional discretionary dollars on the highest interest rates first. Once the highest interest rate debt has been paid, redirect excess funds to the second highest, repeating until all debts have been paid in full. Once you have successfully reduced or eliminated unnecessary debts, you can begin redirecting your discretionary dollars into the stock markets.