Savings and Investing Series: Part III - Saving For Your Life!
The first few steps in the financial pyramid are perhaps the roughest. In Part I of this series we learned about getting into the financial mindset and we forced ourselves to set specific and impactful goals that would motivate us to achieve the financial success to which we are all searching for.
In Part II we discussed the application of self-control and accountability through the implementation of specific controls; adequate income, controlled spending, and appropriate levels of insurance to protect ourselves from the unpredictable things that life tends to throw our way.
While in no way “fun” or “glamorous,” these first two steps were essential for us to master as they form the foundation that we build our entire future on.
If you were in debt and are no longer, you should feel an immense sense of pride and accomplishment. Having successfully set your defined goals, designing your personalized get-well plan, and implementing that plan into action is truly something to be proud of.
All that being said, it is never enjoyable to watch all of your hard-earned money being used to pay for things that you have already used in the past, your debt…
Moving into the Savings step we begin to see, for the first time, measurable increases in building our positive wealth, something that most can agree upon as being favorable!
The establishment of appropriate savings is the final step in our foundation before we begin to see our money work for us in the exciting step of investing.
Really quick, there are a few different types of savings vehicles. The biggest difference between these savings vehicles and investments are that these are insured by the federal government:
Savings Account – A savings account is simply a place to hold your money. You get out of it exactly what you put in, perhaps + .06%!
Certificates of Deposit (CD) – Your purchase of a savings certificate, or CD, allows the bank to utilize your money for a period of time, and at the end of that maturation time, usually 6 months – 3 years, you are given 1-3% interest. Essentially you have given the bank a loan, they have invested your money and have undoubtedly earned more than 7%, and they will give you 1-3% for your generosity!
Money Market Account – Simply a savings account that has higher minimum balances with slightly higher APY… maybe up to 1.4%
U.S. Savings Bonds (I&E) – A bond is an IOU, just like a CD, but instead of loaning the bank money, you are letting the government borrow your money for a defined period of time in exchange for a small return.
With regards to savings it is important to know that one of the things that will help you decide if you should save or invest is your Time Horizon, or the amount of time you have before you may need to utilize the money.
If you anticipate that you will not need the money for 5 or more years I would suggest you consider investing; a topic we will discuss in detail in our next post! If you believe you will need the money in less than 5 years I would suggest placing your money in a savings vehicle.
The reason behind this is that, when invested, the market goes in waves that last approximately 5 years. If you knew you needed the money in 2 years and you invest the money, you are taking the risk that the market will be down precisely when you need the money. In that instance, you would have to be willing to accept that risk or be in a position to move the Time Horizon out further to a time when the market goes back up.
When assessing any type of vehicle in which you are about to park your money in you want to determine three specific factors: Safety, Liquidity, and Yield or SLY.
Safety – How safe is my money from market fluctuations…
Liquidity – How easy is it to get to my money…
Yield – How much will my money grow…
Savings SLY Breakdown:
Safety:
The first thing we need to understand is that savings are not designed to earn us money. Think of savings vehicles as stashing money under your mattress, albeit a bit more securely! Savings provides a secure place for us to store our money; secure from theft, and secure from fluctuating market indexes. For better or for worse, you can rest assured that what you put into a savings account will, almost to the dollar, be there when you need it.
Liquidity:
The next benefit of savings is the high level of liquidity. This is just a fancy term for stating that your money is readily available for your use. Whether you pull money from an ATM, or perform an electronic transfer, your money is likely no more than a few moments away from being in your hand.
Yield:
In finances the cost of having your money readily available, and shielded from market fluctuations comes in the form of practically nonexistent growth. Today’s average APY (Annual Percent Yield) for a savings account is a measly .06%. That means that if you were to place $10,000 in that account, you would have $10,060 by the end of that year.
While I have no quarrels with accepting free money, it really isn’t all that free when you calculate that the rate of inflation is approximately 3%, it means that if you are not earning more than 3% on your money you are actually losing money… Don’t panic, don’t panic, savings are still important, you just have to realize that they are not there to earn you money.
As with all aspects of life, with increased risk comes increased reward. When you invest your money in a higher risk investment, the safety and liquidity are reduced but the potential for greater yield is astronomically higher.
While money placed in a savings account is certainly very safe and very liquid, the cost of that safety and liquidity comes in the form of low yield. This should be a concern but not just yet. At this point we are talking about savings and we need that safety and liquidity, unlike our approach to investing!
Both have their place, but for now we will focus in on savings!
“So, if a savings vehicle earns such poor returns, why would I ever use one?” That is a great question.
Our financial pyramid lists three important portions of the savings level, the Emergency Fund, Reserves, and Goal-Getter funds.
We discussed the importance of the Emergency Fund, in depth, in our article titled Personal Finance Done Right: Breaking Away From The Joneses, However I will provide you a brief wave-top explanation here.
I often ask others a simple question, “when did Noah build the Arc?” While everyone searches the far corners of their brain I simply state “before the rain.” Every single one of us will have some form of a rainy day in our lives, the purpose of the emergency fund is to serve as “insurance,” to ensure that we never go into debt ever again.
The average household needs to have an emergency fund equal to 3-6 months of living expenses tucked away in a generic Savings Account, or Money Market Account, not bonds, not CDs. The money won’t grow a dime, I know, but this is insurance, not an investment.
The reason I say the emergency fund should not be in CDs or bonds is simple, lack of liquidity. When you purchase a CD or bond it is for a specific period of time, usually 6 months – 3 years. If you have an emergency within that window you will be forced to back out of that product before the maturation period. This can lead to either the forfeiture of any interest earned and or an early withdrawal penalty.
Just use a Savings or Money Market Account. This money will sit there, idly waiting to help us prevent that swipe of a credit card or signing of a personal loan when murphy walks in to our life with all of his laws.
The main rule for the emergency fund, IF YOU CAN PLAN THE EXPENSE IN ADVANCE, IT IS NOT AN EMERGENCY! Say it one more time… IF YOU CAN PLAN THE EXPENSE IN ADVANCE, IT IS NOT AN EMERGENCY!
Often times, when life strikes you hard, it may feel like an emergency however I ask you to step back a minute, pull up to get that 30,000’ view and ask yourself these three questions: Is it unplanned? Is it important? Must it be fixed now?
Examples of emergencies that warrant withdrawal from the fund, although not inclusive, include:
Vehicle breakdown
Flat tire
Transmission falls out of car...
Medical emergencies
Covering your family’s expenses
Traveling to visit someone who suffered a medical emergency
Legal fees/fines
So, your emergency fund is in place; she’s your last line of defense between murphy and debt. Now we build your first line of defense and that’s your Reserves!
Think of your reserves as your foresight or your ability to anticipate future expenses before they happen. This will ultimately prevent many of these “emergencies” from ever occurring in the first place and with further protect that emergency fund!
Let me give you some examples:
Every household has standard expenses that they just know are going to happen; insurance premiums, preventative vehicle maintenance, scheduled home maintenance, birthday’s, Christmas gifts… just think about your own expenses that come up throughout the year.
My personal recommendation is that if you know these expenses are going to happen, try saving for these things over the course of the year. For example, let’s say our car insurance is $600/year. At the first of the year, our renewal period, we pay this bill in full, because we receive an additional 15% savings over paying monthly. After we make the payment, we simply divide $600 by 12 months and we pay ourselves $50/month into a savings account we nicknamed “Car Insurance Fund.”
One great benefit of savings accounts are that most every modern bank allows you to open practically a limitless number of accounts without any fees. Additionally, you can give these accounts nicknames vice “share savings account XXXXXXXXXXX.”
We personally have numerous savings accounts for such things. One big expense each year for many is Christmas. The average American spends over $900 on Christmas gifts each year and they act surprised when they are paying these purchases well into the new year. Last I checked, Christmas happens the same day each year…
Nelli and I have a chart that dictates how much we will spend for each person for birthdays and holidays each year. Incredibly nerdy, I know, but remember, in our Being Normal series I explained the mess Nelli and I were once in and how we swore to never again make those mistakes! This chart enables us to tally up how much we are going to spend on gifting throughout the year and we simply divide that number by 12 and we pay ourselves a monthly payment into our “Gifting” account! This ensures that we are never caught off-guard by events that are plannable for eternity!
The cool thing is that as you begin to preplan all of these expenses, vehicle and home maintenance especially, you are planning to provide preventative maintenance throughout the year, which ultimately prevents, or lessens, the likelihood of emergency failures from occurring. This further cushions your emergency fund and protects you from ever feeling the grips of debt!
Finally, we move onto the more fun side of savings, the Go-Getter, or Goal savings! These are the things that you want to purchase or vacations you want to go on within a 1-4 year timeframe.
These are also the areas where you may consider using CDs or Bonds as they do not have to be as liquid and the extra percent or two can help perhaps earn you an extra dinner or two on that next vacation.
Nelli and I have numerous Go-Getter savings accounts. First of all, we have our vacation fund. We are huge Disney World fans and we are keenly aware of the expense of such a trip. We know that we want to take the kids there in a specific time frame in the future so we simply took our estimated cost of the trip and divided that number by how many months we have to prepare for it. Say the trip is estimated to cost $5,000 and we have 36 months to save, we would pay ourselves approx. $140/month into our vacation fund!
Examples of savings accounts that Nelli and I have are:
• Emergency Fund (Emergency ONLY!)
• Automotive Repair/Replacement (Reserve)
• Insurance Premiums (Reserve)
• Vacation Fund (Go-Getter/Goal)
• Gifting (Go-Getter/Goal)
• Home Expenses (Reserve)
• General Savings (be careful with this, or else it can become an unbudgeted slush fund!)
The main take away here is that through the utilization of proper planning, you can mitigate the “sticker shock” of many purchases that can, in many instances, be planned for well in advance.
Getting to this point takes discipline, as you will likely want to invest and have your money start earning the “big bucks.” We want you to invest as well, but we need to do everything in the order that is most appropriate; the house must be built from the bottom up.
If you do these steps out of order you are opening the door for murphy to walk right in and you become one emergency away from having him knocking down all that you have worked for!
Remember, build your house of bricks, not of cards!
