The Waterfall Method
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This lesson will take you step-by-step through each of the most important pots for holding your money and the exact order to fill those pots. We'll tackle important topics like eliminating debt, taking advantage of free money from your employer, and making everything as tax-efficient as possible.
I just killed a kitten. Just kidding, just seeing if you were paying attention. I'm not a murderer.
We know exactly where you are. Not in a shady, we're spying on you through your webcam kinda way, just that after learning some of the basics we know you're ready to start investing and see those returns, which is exactly how you should be thinking at this point.
But first you need a financial fitness check. We like to think of it as a super classy champagne waterfall, like the kind you might find at the birthday of a reality TV star. Only instead of carbonated grape juice, it's your money that's flowing. And if you set up the glasses in the right way, it will set you on the path to being extremely smart and financially sound.
1. Kill your high-interest debt
If you have debts with an interest rate above 5% like on a credit card, you absolutely must pay those off before you do anything else. Why? Well credit cards charge a lot of interest, as much as 18% or more. Because you'll be paying more in interest than you'd make on pretty much any investment, you'll be losing money by not paying down your debt.
2. Build an emergency fund
We should all be ready in case something unexpected happens. An illness, a layoff, a terrible decision to buy the worlds most expensive dinosaur bones from Nicolas Cage. Otherwise, you're gonna have to go into debt to support yourself before you're back on your feet, and then you'll have to start the waterfall all over again. So it's smart to set aside three to six months of expenses. We recommend three months for singles, six for families, and to keep it somewhere low risk like a savings account.
You're probably thinking, didn't he just spend 15 minutes telling me I should invest? But think of this as a safety net for your financial future.
3. Maximize your employer match
Congratulations, you're now high-interest debt free, and you have your emergency fund. Now lets get you some free money, because that's what an employer match is.
If your company gives you extra money when you contribute to your retirement account, called matching, and you're not taking advantage, you're essentially turning down part of your salary. Don't do that. Get that money.
4. Get smart about taxes
The government. They want us to save for retirement because then, when we get old, we won't become expensive problems for them and society. And the big incentive they offer to do that is these tax advantaged retirement accounts. Money in these accounts, sometimes called a TFSA, a Tax Free Savings Account, or RRSP, they all grow tax free. (Note: The U.K. equivalent of these accounts is a ISA or a Pension)
5. Kill your low-interest debt
Now the champagne's really flowin'. You got four glasses full. There's no more high interest debt holding you back, you and your family are secured with an emergency fund in place, free money from your boss is coming in, tax free accounts are up and running.
The next best thing to do with extra cash may be to pay down other debts. Even those with an interest rate of less than 5%, like mortgages, student loans, car loans. Why? Well these low interest debts still have some interest. Which means they could be eating into any financial gains you make through saving and investing.
6. Set up some financial goals
Now let us pop some bottles. Because if you've made it to glass six you definitely deserve a toast. Seriously, making the most of employer and government retirement programs and paying off all your debt, it's a huge achievement to celebrate.
But even better than a course of mazel tovs, it's time to make some decisions. So one option you have is to invest in a personal account. An investment account that gets taxed. You could also choose to max out your retirement accounts.
Another option is to consider putting money toward larger savings goals. Whether it be a new car, house or graduate school for your nine children. Maybe that's too many children. In which case you should really have RESP accounts (Note: In the U.K a JISA allows you to save for your child's education, tax-free).
Remember, if you have money that you intend to spend on a big purchase, house, wedding, college, within the next few years, it should go in a savings account. Any investment folks who guarantee you gains in the short term, are people to be suspicious of.
But you know that. After six full glasses of financial health, you're expert level now. Chin chin.