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Investing can be a powerful way to grow your wealth over the long term. Of course, you have to be ready to put up cash to buy into different investments. How much you can afford to invest really boils down to your disposable income. You'll want to make sure your financial house is in order to avoid overextending yourself.
Before you start investing, budget for all your expenses first, then calculate how much you have left over for investments. Read on for a simple way to calculate how much you can comfortably afford to invest.
Budget for Essential Expenses Before Investing
An effective budget is really just a plan for what you'll do with your paychecks. A primary goal of budgeting is to make sure your spending doesn't exceed your earnings. Otherwise, you'll likely wind up accumulating debt to cover the difference. With that said, your budget should make room for the following:
- Everyday expenses: This includes everything from your housing payment to utilities and groceries. Student loans, credit cards and other regular debt payments fit into this category too.
- Emergency fund: Set aside some money to cover living expenses in case of an emergency like a job loss, unexpected medical need, or last-minute car repair.
- Financial goals: Your budget should also make room for financial goals. This might mean paying down debt, or saving for a down payment on a home. Breaking big goals down into smaller monthly savings targets can help you get there over time.
- Debt: Your debt load is another thing to consider—particularly on high-interest accounts like credit cards. If you're only making the monthly payments and not really chipping away at these balances, investing might not make the most financial sense. Even if your investments are growing, those returns could be a wash if you're being hit with monthly interest charges elsewhere.
- Discretionary spending: This refers to nonessential spending like eating out, shopping, or going out with friends. It can be tempting to shrink this part of your budget to save money, but going too lean here could leave you feeling deprived. Try settling on a reasonable monthly amount to spend in this category, then enjoy yourself without the guilt.
Calculate How Much You Need to Save For Retirement
Your budget is the most important piece of the puzzle, but retirement saving is also important to consider. If you have access to an employer-sponsored retirement account, you don't necessarily have to wait until you've met every financial goal before participating.
Even if you have debt or are growing your savings account, it's still wise to funnel some portion of your earnings toward retirement—especially if your employer will match your contributions. It's free money that can benefit from the power of compound interest.
It's possible to balance your financial goals while also investing in your future. Most experts recommend saving at least 15% of your income for retirement. If doing so means struggling to pay your bills, however, consider dialing that number down to something that feels more compatible with your budget. You can make it a goal to increase your contributions down the road.
Now let's say your budget covers all your expenses and allows you to save for your financial goals while setting aside a little something for retirement. Your high-interest debt is paid off, and your emergency fund is also looking good. At this point, any additional income can be used to bump up your investments.
Choose What You Want to Invest In
The idea is to mix things up and diversify your investment portfolio to help mitigate risk. Below are some options to consider:
- Individual stocks: When you buy stock, it gives you an ownership stake in the public company that offered it. Stock prices are in constant flux, and there's no foolproof formula for picking winning stocks, but you can turn a profit if you buy low and sell high. Keep in mind that stock investing can be risky, and it's only a good choice if you're already in a strong financial position.
- Mutual funds: A mutual fund is a portfolio of investments that typically includes small shares of different stocks, bonds and other assets. The fund is professionally managed and structured in a way that can provide diversification. Some mutual funds mirror a major market index, like the S&P 500.
- Exchange-traded funds (ETFs): An ETF is a basket of investments that's tied to a market index. ETFs are similar to mutual funds, but they're passively managed and can also be traded anytime, just like individual stocks. With mutual funds, an investor buys stocks and holds them for a longer period of time, regardless of market fluctuations.
- Bonds: When you buy a bond from a corporation, government entity or municipality, you're essentially loaning them money, and they'll pay it back over time with interest. Bonds are considered safe investments, though returns are typically lower than high-risk investments like stocks.
- Real estate: There are multiple ways to invest in real estate. You might like the idea of buying an investment property and renting it out. Alternatively, you can buy, fix and flip properties instead of being a landlord. A real estate investment trust (REIT) is another way to invest without ever buying a property. It allows you to invest in companies that buy and manage residential or commercial properties.
The Bottom Line
No matter how you decide to invest, it's important to remember that returns are never a sure thing. The goal is to build an investment portfolio that's in line with your risk tolerance, unique financial situation and long-term goals. (A financial advisor can come in handy here.)
Investing is just one part of your financial big picture. Maintaining strong credit is just as important as it directly impacts your borrowing power. Free credit monitoring with Experian allows you to stay on top of your credit health so you can manage your money with confidence.