Becoming Financially Secure: What to Do First

Photo: Philip Brewer

Standard financial advice is full of things to do first — emergency fund, 401(k), pay off debts, start investing, stockpile emergency supplies. What really comes first? (See also: Be In Charge of Your Finances)

Because everybody's circumstances are different, there's no one true answer that applies to everyone. Instead, the right way to approach this problem is with a mental model — a way to think about these issues that can guide you to coming up with the right answer for your particular circumstances.

Here's my stab at one.

First, Stop the Penalties

Probably the most expensive mistake you can make with your finances is to find yourself paying penalties for screwups. I'm talking about things like:

  • Late fees
  • Overdraft fees
  • Disconnect/reconnect fees for utilities
  • Penalty interest rates

If you have any accounts that are racking up penalties, that's the first thing to take care of. All your spare money should go there. Engage in some emergency belt tightening, if necessary, to free up some cash. In this one case, it might even be worth going further into debt to cure this sort of problem. (It depends on the interest rates you have to pay. For example, interest rates on a payday loans are often so high that you're better off just paying the penalty rate on your credit card.)

Second, Make Things Safe

You can prevent most of those most horrible problems with a very small emergency fund, one just big enough to smooth over glitches.

My suggestion for a minimal emergency fund is roughly the size of your biggest single bill — maybe your rent payment or mortgage payment.

Of course a small emergency fund like this doesn't provide much protection if there's a real emergency — you lose your job or have a large expense not covered by insurance. Where it helps is when something goes very briefly awry.

Suppose your payment to your insurance company goes astray and you need to write a new check today or else your insurance will be canceled. The problem will be sorted out soon enough — either the check will be permanently missing and you can just stop payment, or else it will turn up and the insurance company will refund you the overpayment. But right now you need a little cash to keep your insurance from being canceled.

A small pool of available cash like that is almost immediately self-funding, covered by the late/overdraft fees avoided.

A very similar move is to stockpile some staples in your pantry. When I was younger and my finances were out of control, I'd sometimes find myself buying an expensive meal at a nice restaurant because I was out of money. (In those days, grocery stores and cheap restaurants didn't take credit cards, but expensive restaurants did.) Have enough food on hand that you can always prepare a meal.

Similarly, keep some cash on hand. Now that everyone takes debit cards, currency is starting to seem like an anachronism. But even today there are some problems best solved with actual paper money.

Third, Pick Up Free Money

Once you've got your finances free of ongoing penalties and safe from constant danger of new penalties, the next step is to pick up as much free money as possible.

Probably the biggest single source of free money for most people is an employer match for your 401(k). (A lot of employers stopped matching 401(k) contributions during the financial crisis, but many have now resumed the practice.) A match of 50% or 100% on the dollar is so much money, it completely dominates any investment return; you probably don't want to make any other sort of investment until you're picking up the full match on your 401(k).

Another source of free money is what you can pick up when all the aspects of your household are running smoothly.

  • When you've got an emergency fund that's larger than the bare minimum, you can afford to stock up when there's a good bargain at the grocery store: free money.
  • When your pantry has all the staples, you can pick up whatever's fresh and cheap at the grocery store and know that you'll be able to turn it into a meal: free money.
  • When you've got a bit of daylight between what you earn and what you spend, you can start paying down debt — and stop paying so much interest: free money.
  • When your debts are paid off and you're maxing out your 401(k), you can start investing more aggressively, and hopefully earn some higher returns: free money.

Fourth, Everything Else

Up to here, the priorities for everyone are about the same. At this point, personal factors begin to make a bigger difference.

Is your job very secure? Then maybe you can start investing even while you're getting your emergency fund fully funded.

Do you have any debts at high interest rates? Getting those paid off early is a priority, while long-term, fixed-rate debt (like some mortgages or student loans) can be more comfortably paid off over time.

Do you live in a disaster-prone area? Then expanding your pantry from the bare minimum to something that will see you through a blizzard or flood or a truckers strike might want to come early.

Your personal situation determines what's best for you. But now you have a mental model for figuring out what to do first: Stop the penalties, make things safe, and pick up free money.

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Guest's picture
nita p

great article. one book that was really helpful was i will teach you to be rich when i was starting to organize my finances. if you're interested in more ways to save through sharing deals with friends, check out

Guest's picture

Paying down debt should be one of the first ones listed with along with penalties. The interest on that might as well be considered it. People always wonder if they should pay down debt first, build up savings first, or work on both at the same time. For me, if a credit card is charging 18% interest and a savings account is only earning less than 1% interest, it makes more sense to put all money towards the debt to stop the interest. Of course, everyone's situation is different and they will need to evaluate what works best for them. Get that debt paid down as fast as you can, and you not only have that weight lifted off of your shoulders, but your credit score goes up as well earning you better interest rates in the future.

Philip Brewer's picture

A penalty interest rate can be just about double the rate someone who doesn't miss payments has to pay. That's why I think it's so important to get that minimal emergency fund set up early: Keeping a few hundred dollars on hand is how people avoid missing payments, which is how they avoid getting socked with penalty rates.

Suppose you have a large amount of consumer debt—let's say $10,000. If you're paying a 24% penalty rate, you're paying $200 a month in interest. Let's also say that you can scrape together $500 in cash. What do you do?

If you use the $500 to pay down your balance, that saves you $10 a month.

On the other hand, if by keeping that $500 in your checking account as an emergency fund you can quit missing payments, and if no longer missing payments means you get moved off the penalty rate and only have to pay the regular rate of 13%, your monthly interest payments drop to just $108; that saves you $92 a month.

Now, your $500 is also earning a pittance in interest. If you can earn 0.8% on the money, you'll pick up 33 cents a month. But that's not why you hold the cash. You hold the cash because it lets you make all your payments on time, getting you off the penalty rate.

Of course you're right that getting out of debt comes next. (Or, maybe, next-but-one: If you can get a 50% or 100% match on your 401(k), it's probably worth fully funding that, even before you pay off your debt.)

Guest's picture

I think standard financial advice is standard because it's tried and true. However, I think the advice in this article is a great starting point. There is no point trying to sock away extra money in a retirement account when you're paying penalties on credit card debt or the like. Doing so skyrockets the interest rate you're already paying if you're carrying debt.

I think basically the gist of this article is to manage one's cash flow first so you're not losing money through unnecessary payments.

Guest's picture

I think this is a pretty good blueprint for people who don't know where to start! Something I'd add: save AS MUCH as you can, so you can get to financial independence as early as possible in life. Once you have that, you can choose any work you like, or choose not to work! By "AS MUCH", I mean I save about 50% of my income. I'm trying to find ways to save more, and put my money to work for me and my life of freedom.