This is part 3 of a 9-part series about the Founding Four principles of your financial plan. Part 1 introduced you to the four critical activities you need to work on as the basis for every financial plan, and Part 2 introduced you to the first of the four principles, Saving. Here in Part 3, we’ll go deeper into how to save, and I’ll give you some suggestions about where to do it.
Ideally, you should be saving for goals that you want to accomplish within the next 5 years. Any goals further out than 5 years can include some investment component to it, which we’ll cover in a later blog post in this series.
Some very common goals I see clients saving for include vacations, college expenses, a special family event like a bar or bat mitzvah or quinceañera, a second home or a boat, RV, etc.
If you are adequately handling the other three parts of the Founding Four, I’m all for you saving for things you want instead of just things you need. After all, Rich Guys understand that life is short and we only get to do this life once. Live it to the fullest and be bold in what you want out of it!
Keep your savings separated
Generally, I’m a big fan of keeping your accounting as simple as you can: one IRA, for example, instead of small 401k balances scattered around at former employers, or one consolidated debt rather than 10 minimum payments to manage. However, in the area of saving for short-term goals, I believe you need at least two savings accounts: one for your Emergency Fund (that you never touch except in actual emergencies), and at least one more for the other short-term goals.
All things being equal, your first priority needs to be saving for your Emergency Fund.
What’s an Emergency Fund?
An Emergency Fund is simply a savings account that provides a pool of money for you to dip into whenever life throws those unexpected, negative consequences at us. It may mean a major home repair, deductible money for insurance needs, quick travel money in the event of a family crisis, a job loss, etc. It’s definitely not meant for casual spending – treat your emergency fund savings as a literal lifeline.
How much should you save in your Emergency Fund?
Everyone has a unique dollar amount that provides the level of psychological comfort. Some people would be thrilled to have $1,000 in their emergency fund (and if you’ve never had one before, you will, too). Others don’t feel secure until there is $25,000 or more in one.
Whatever final number you choose, your Emergency Fund balance must be at least 3 months of living expenses (not necessarily total income). This will protect you in the event of a job loss for at least 90 days.
Ideally, you’ll want up to 6 months’ expenses or even more, but your first goal should be to protect against income loss for at least 3 months before you begin saving for any other short-term goal.
Without an Emergency Fund, the only place most Americans can go to keep things afloat is to a credit card. Sadly, 80% of us have less than $5,000 in savings. Interestingly, that same 80% live literally paycheck-to-paycheck.
(There’s that Pareto Principle or “80/20 Rule” working again, that we mention so often here at TLRG. But I digress.)
It’s actually more serious than that. Studies show that millions of American families are only one missed paycheck away from a downward financial death spiral that will end in bankruptcy.
Never mind that, however; that’s what the masses do. That’s not you. You’re an up-and-coming Rich Guy, so you plan ahead, stay focused on your goals, endure the discipline and sacrifice that all Rich Guys eventually master, and keep your emotions in check along the way.
How to build an Emergency Fund
The secret to building an emergency fund is, obviously, to spend less per month than you take in, and save the difference.
But I’ve found that people don’t do that with the discipline necessary to actually reach the goal of 3-6 months of bills. Something will always come up, or you’ll impulse buy, or browse Amazon in a moment of boredom, and it’s gone before you know it.
The secret is to add your savings to your monthly budget and treat it like a bill.
In our early days, we budgeted only $50 out of each paycheck and set it up at our bank to move it to our savings account automatically every payday. No matter what, that $50 was already in savings the same day the paycheck hit the checking account. In our minds, it was already gone, like our 401k contributions. It was just a bill.
And slowly but surely, that $50 grows. In a year you’ll have $600 in the account; in 3 years, you’ll have $1800.
I know that’s not even close to a month’s expenses for most people, let alone 3. That’s why you need to put as much away as you can, even if it means you pick up additional income in the short-term. You could drive for Uber or Lyft, pick up some extra hours at work, or deliver pizza a couple of nights a week; whatever you need to do to begin down the path to financial independence, you need to be willing to do.
As you make more money and pay down debt, you simply increase the amount in savings until you’re at $100, $150, even $500 or more of each paycheck being moved automatically, like a bill on auto-pay, into savings.
Once you’ve reached that 3-6 month money goal, consider moving that contribution over to other parts of your financial life.
And if you ever need to dip into that fund, fine, but remember, you have to fill it back up again to the same level.
How to save your Emergency Fund
The key to an emergency fund is to be readily available in just a few days without risk of it being down in value due to market volatility. Like any other short-term, “need it at the ready” money, your emergency fund can’t be invested in the traditional sense, because you might need it tomorrow, and it the stock market is down, you may have to sell the shares of your fund at a loss.
But here’s the dilemma: 6 months of expenses can be, for some people, $40,000 or more, and that’s an awful lot of money sitting in your local bank savings account earning 0.25% or less. And since this money only gets accessed in emergencies, it may be years before you actually use any of it. In which case, a large sum of money might potentially earn almost no interest (and certainly not keeping up with the rate of inflation), for years.
A Rich Guy Rule to remember is: your money must always make money. It’s not enough to just leave the money sitting idle – it needs to be productive while it’s waiting to be used.
It’s not the best idea to leave $25,000 or more wallowing in a money market account or typical savings account, if you have no immediate need for it. So, here are a couple of ideas about how to save your Emergency Fund so that it actually works for you, instead of just sitting there waiting for you to need it:
- Create a Savings Account / CD “Ladder” at your local bank or credit union, or alternatively,
- Create a money market / bond ladder at a low-cost brokerage firm for an even higher return that is potentially free of federal income taxes.
- If you have a larger fund, combine both ideas: invest it using a combination of a bank “ladder” and a bond “ladder” in a low-cost brokerage account.
Let’s look at both strategies briefly:
First, a “Ladder“, in investment terms, means instead of putting all of your savings into one “basket”, you buy several different investments with staggered maturity dates, so that a portion of your money is always maturing (meaning, your cash is being returned to you). In the case of a $25,000 emergency fund, you might keep $5,000 in cash or money market, and buy 4 more $5,000 bank Certificates of Deposit (CDs) with different maturities: one that matures in 90 days, one in 180 days, one in a year, and one in 2 years.
Using this strategy, you always have $5,000 in cash at the ready at any given moment, and you always have at least $5,000 more that is just about to mature and be returned to you in cash.
Let’s see what this looks like in theory:
Instead of just leaving $25,000 in a bank savings account, you instead “stagger” the money using different savings vehicles at the same bank, to get a better overall rate of return on the money.
Look at the example here: we have $5,000 in our basic savings and 4 certificates of deposit with maturities ranging from 90 days to 2 years.
In this example, we always have $5,000 ready to go in cash, but we use the other $20,000 to purchase Certificates of Deposit with different maturity rates. The very basic rule of thumb is, the longer you let someone use your money, the more interest they pay you for it.
For those who are a little more investment-savvy or want an even higher rate of return on this strategy, you can do the same thing here, but instead open your emergency fund account at a low-cost brokerage firm and buy bonds or brokered CDs instead of your local bank CDs.
As a CD matures, you use that money to buy another one at the far end of your time frame. So your just-matured CD money goes to buy another one out 2 -5 years.
Taking it up a notch for bigger savings funds
What if you want to keep $50,000, $100,000 or even more ready for use? $100,000 is an awful lot of money to have parked in a bank, earning essentially nothing. Let’s show you a way to keep things safe AND earning money using a more complex strategy:
As an investment advisor, I often use this next approach for clients who have enough money saved that they really should be investing it, but also don’t want the daily volatility risks of the stock market.
For those clients, we create a much longer ladder by buying US Treasury, Agency or Corporate Bonds, or my personal favorite, municipal bonds, for maturities going much further out than CDs.
The concept is the same as before, but because we’re working with a larger pot of money, we can extend out the maturity dates for even decades, and therefore get an even better overall rate of return on our savings.
Think of it as two pots instead of one, but both pots are following the same concept and working toward the same ultimate goal.
In this scenario, let’s say we have $50,000 in our fund.
My advice for you would be to keep your original $25,000 close to you at the bank, and relatively close to maturity at all times.
But for the rest, you can extend the maturity dates and use bonds instead of CDs, to grab double or more the interest your bank savings is earning.
Some bonds can pay better than 7% per year, and muni bonds are always federally tax-free (and many munis are even free from the AMT tax).
I won’t go into muni bonds and their features here, but if you want to read up on the pros and cons and features of muni bonds vs. taxable bonds, I’ve linked you an info sheet here.
This isn’t a terribly sophisticated strategy, but you do need to know about bond credit quality and the inherent risks bonds have that, while far less volatile than stocks, can still cause problems if you’re not well-versed about them.
Although you certainly can buy bonds yourself through a discount brokerage firm, you might want an advisor who understands the minutiae of the various bond classifications and risks, to manage the bond purchases for you.
(A quick note: in this strategy, it’s probably going to be cheaper to work with a broker earning commission on the bonds instead of a fee-only fiduciary advisor like me if you’re only investing for this strategy. I am far less expensive in handling multiple accounts and money that really needs to be managed, and working closely with clients who need a financial plan and a coach. But in this example, if we only need to buy a new bond or CD when one matures, the commissions you’d pay a stockbroker should be less than a recurring money management fee. Plus, once the ladder is in place, there is relatively little to manage.)
And finally, where should I save?
I’m a big fan of credit unions and community banks, so start there. And I put my money where my mouth is: both my family’s personal accounts and all of our business accounts are at local credit unions. Not only are credit unions by nature non-profit, member-centric organizations, but they’re also some of the better lenders.
But don’t be loyal to a fault. If your current bank isn’t offering competitive rates on their CDs and savings accounts, there is no reason not to shop around. The internet is now rapidly filling with online-only banks that provide all the services of your local bank (except the branch to walk into), and usually, their savings rates are better than you’ll get locally.
If I was going to do this myself and stick with an online bank solution, I’d go with Ally Bank – with some of the lowest fees and best savings rates around, this would be my personal choice for my emergency fund and other savings needs.
Join me soon in Part 4 of the Founding Four series, where we start talking about debt management!