The Prerequisites to Investing

You might think that all you need to start investing is some money. But it's not that simple. When you invest, you put money at risk. That's a fancy way of saying you might lose the money. For example, if you buy stocks or bonds, those investments can become completely worthless if the company goes bankrupt. Even a company that is doing OK can see its stock dramatically drop when the business climate changes.

So when is it safe (and worthwhile) to take this kind of risk? That's what these prerequisites are really about. Here's the list of what you should have before you begin investing:

1. A steady income that provides you with enough to live on plus a little more. See Getting Started (rule #1).
2. No credit card debt, or other "bad" debt. See Getting Started (rule #2) and Good Debt and Bad Debt. It's OK to use a credit card as long as you pay off the balance each month. Then you aren't really incurring debt.
3. Substantial equity in a home. I'll say some more about this below.
   
4. Savings that amount to six months of your income (your combined income if you are married).
5. Health insurance, and also Life insurance if you are married.
   

The point to these prerequisites is to make sure that money you invest is money that you can truly afford to lose. If all your investments fall to zero, and you are laid off from your job, then the savings are there to see that you will have some time to find another job.

The insurance prerequisites are necessary to cover unexpected but potentially catastrophic events. Without health insurance, for example, your entire savings and investments could be wiped out by a sudden illness. Many jobs provide insurance as one of the employee benefits, but if you are self employed, or your job doesn't provide insurance, then you should purchase insurance for yourself (and your family) before even considering investing.

This brings us to the home. Why own a home before starting to invest? The reason is that a home is really your first and your best investment. It not only provides you a return on your investment, it also gives you a place to stay, and saves you the rent you would otherwise pay. On top of that, the government subsidizes your investment by giving you a tax break on the interest payments on your mortgage.

Your equity in a home is the value of the home minus the amount of the mortgage. So if you bought a $300,000 home, and borrowed $250,000 to buy it, then your equity is $50,000. Over time your equity increases as you pay off the mortgage. Substantial equity is at least 20%. So in the example of a $300,000 home, you should have at least $60,000 in equity before considering investing.

There are lots of things to consider when buying a home, I could write another column just on that topic. But there is one thing which is so vital to your financial health, that I have to mention it here. Never buy a home using a variable rate mortgage. The standard mortgage is a 30 year fixed rate, and that is the way to go (or a 15 year fixed rate if you can afford it).

With a fixed rate, you know what your costs are in advance, and you can determine if you can afford the home. As long as the payments are within your means, and you plan to stay in the area for a while (five to ten years), the home should be an excellent investment. The equity in your home provides you with a margin of safety against the normal fluctuations in home value.