Getting out of debt is a wonderful feeling. I recently finished paying off my car, and it's a palpable relief. Now I can pay myself instead of paying someone else.
Getting out of debt may take no time at all, take a few months, or several years. You can get accustomed to writing those checks every month. When you finally pay something off, that is a great opportunity to capture that money and put it to work for you. Don't allow yourself to start spending it - sure, go ahead and treat yourself a little for clearing that milestone, but do look ahead towards your next goal.
With debt out of the way, you can focus on saving and investing. "Saving" just means putting money aside and not spending it. It's technically "saving" even if you stuff dollar bills into your mattress. "Investing" actually puts money to work for you. You are now switching places with your lenders: you are lending your money to someone else, and expecting something back from them in return. That might be regular interest, a fixed payment at the end, or some indeterminate growth of value.
There are a broad range of investments available out there. If you take one lesson from the subprime crisis and credit crunch, it should be this: never buy an investment that you don't understand. Financial people can earn huge sums of money by creating exotic investments and selling them to people, but 99% of us should only use a handful of tried and true options through our entire lives.
This session will cover "safe" forms of investing. The next will cover more exotic forms. I'll briefly look at each type of investment, how it works, and why it might be appropriate to use.
BANK SAVINGS ACCOUNT
What? You got one of these for free when you opened your checking account. It comes with a tiny interest rate, probably somewhere around 0.25%. It is 100% FDIC insured. (As with all FDIC/NCUA accounts, it is insured up to $100,000 per account. Through 2009, it is insured for $250,000.) You can move money in and out almost instantly.
Why? Don't use this if you can avoid it. It isn't as liquid as your checking account - in other words, it's a bit harder to move money in and out. And the interest you earn is practically nothing. If you don't have any of the later options in this session, then park your extra money here while you're opening a better account. You might consider parking some emergency money here to cover things like insurance premiums, but these days most of those charges can be put on your (paid off!) credit card, and you'll have time to tap an online savings account by the time your statement comes.
ONLINE SAVINGS ACCOUNT
What? This is an online account that pays a (relatively) high interest rate. You tie it to your traditional checking account. After that, you can move money back and forth between the two; it typically takes between three days and a week to execute a transfer, during which time you won't be earning any interest.
How? Go to bankrate.com to search for the current best options. Make sure that there is no account fee, and that you have enough money to open it. (Try to avoid one that has a minimum balance requirement after opening.) Be sure that it is FDIC insured! It doesn't really matter whether it is technically a savings account or an MMA (Money Market Account), as long as it is FDIC insured. Check out the star rating - I personally would only choose a bank 4 stars or higher, but again, as long as it is federally insured and you have less than $100,000 in the account, you should be OK. Periodically re-visit this page, perhaps a few times each year, to see if rates have significantly changed or you have enough savings to enter a higher-paying account. I have jumped from ING Direct to Grand Yield Direct to Capital One Direct Banking over the years; my rule of thumb is that if I can make 0.5% more at another bank, I'll switch.
Why? Online savings is perfect for your emergency savings fund. As a bonus, because it's harder to access than your regular savings fund, you're less likely to tap it unless you really need to do so. This is also the perfect place to keep savings that you expect to spend within the next year or so - say, if you're saving for a new car or a down payment for a house.
CERTIFICATE OF DEPOSIT (CD)
What? With a CD, you give the bank a sum of money. They keep it for a pre-determined period of time that you choose - generally anywhere from three months to five years. At the end of that time, you get your money back, along with a pre-determined amount of interest. If you're investing $1000 in a CD that pays 5% for 1 year, at the end of that year you'll get back $1050. If you invest in a CD that pays 5% for 5 years, at the end of those years you'll get back $1276.28, thanks to compounding interest. (Edit: CDs may or may not re-invest your earnings back into the CD; if they do not, you will get some of your earnings back each year. In that case, you'll get back a total of $1250 by the end of 5 years.)
How? Again, I like using bankrate.com to find the best rates. You can also check for advertisements from your bank or in the paper, but don't rely on them alone. Remember, if a bank is spending money on advertising, that's money that they are not spending on giving you a higher interest rate. Be sure your bank or credit union is FDIC/NCUA insured. Only invest money that you don't plan to need in the near future, and keep it there through the end - you'll pay a penalty if you withdraw it early. Most CDs will automatically renew when the term is up - for the same duration of time, but at the current interest rate - so watch your mail and tell them not to renew when it's coming up.
Why? CDs are perfect investments if you know about how long it will be until you need to make a purchase. They generally (but not always) will offer a slightly higher interest rate than an online savings account; unlike the online account, though, the interest they pay is fixed, so you don't need to worry about the rates going down and you can plan better.
Treasury Inflation-Protected Securities (TIPS)
What? This is less common, but I wanted to include it here anyways since it's the ultimate "safe" investment. TIPS are sold by the federal government, and like regular Treasury bills, are considered the safest investment on planet Earth. The key feature of TIPS is that the rate is tied to inflation, so that you will be protected if inflation suddenly spikes. In other words, if there is no inflation, you might earn just 0.5%, but if inflation jumps, you could earn 20% or more, whatever the current rate is.
How? I haven't bought these myself, but you can get them from any brokerage (think Charles Schwab) or your regular financial firm (think Vanguard, Fidelity, etc.). You can also buy them directly from the Treasury online.
Why? This is the very safe place to be if you're worried about your money and the economy. The rates are low, but you're buying peace of mind. TIPS are good to include in your retirement account as you get closer to your retirement date. For the rest of us, they probably aren't appropriate unless you're very conservative.
And that's it! Unless I'm overlooking something, this concludes the entire range of good "safe" investments out there. These are excellent places to park your money, and different places are appropriate for different goals. Next up, we'll be looking at the riskier but more lucrative investment options available to us.