We all know we should be doing it. But by and large, we are not. In order to be successful in handing your money, you must make savings a priority. That means, when you get paid, you need put money into savings before you do anything else. Pay yourself first. You need to save for three specific things: 1) Emergencies, 2) Purchases, and 3) Building wealth for retirement.
1. THE EMERGENCY FUND
When I was a little girl, my mother told me that I should save for a rainy day. Now, when you are 6 or 7 years old, you think that saving for a rainy day means having money to go to Chuck E. Cheese instead of the park when it’s raining out. As it turns out, “rain” looks a lot more like a cracked radiator, a leaky roof, a vet bill for kennel cough, or an emergency room copay. “Rain” looks a lot like life.
“How much should I save?”
Most financial professionals agree that an adequate emergency fund is enough money to cover 3 to 6 months of expenses. That way, if you get laid off (which is the worst money fear people have), you are still able to pay your bills until you find another job without having to dip into your retirement fund, borrow from family, or live off your credit cards.
Now for many people, this is a lot of money to save! Depending on your lifestyle, your full emergency fund could be anywhere from $5,000 to $25,000 (or more). However, if you are familiar with Dave Ramsey and his Baby Steps, he recommends saving a starter emergency fund of $1,000 and then begin to pay down your debt. This amount of money is a great place to start with your emergency fund because most people can accomplish saving this much in a few months or less and it creates a little buffer between you and life. It won’t last long if you get laid off, but it will cover the small emergencies that come up, like a blown tire or an emergency root canal.
Families who have high monthly expenses, however, might want to put a little more aside than just the $1,000 for their starter emergency fund. Some people like to start with the amount of their house or car insurance deductibles. I have found a good rule of thumb is to save about 4-5% of your yearly household income in your starter emergency fund. So if you make $25,000 per year, you should shoot for $1000-$1200. If your household makes $75,000, you save around $3000-$3500.
Not every family is the same, so you have to figure out what is best for you. Some people might choose to save the full emergency fund before moving on to paying off debt if their total debt is substantial. If would like my recommendation for your personal situation, please feel free to contact me.
“What exactly should I use my emergency fund for?”
Now, let’s clarify the definition of an “emergency”, because once you have that $1000, $5000, or $20,000 in the bank, some of us spenders are WAY too tempted to look at that money as a leather couch fund or a bass boat fund. NO! It is for EMERGENCIES. ONLY. And gentlemen, needing a bigger TV for your Superbowl party is NOT an emergency. Ladies, buying that leather jacket at the end of season clearance is NOT an emergency. Emergencies are unforeseen circumstances that MUST be addressed immediately in order for your life to continue. Good examples of this would be car breakdowns, doctor copays due to sickness or injury, or home repairs that affect basic needs (i.e. your pipes freeze or your furnace dies).
Many expenses that we want to consider emergencies, aren’t really. You KNOW your car will need routine maintenance, tires, brakes, etc. Plus you KNOW that your car will someday need repairs. That’s why it is smart set aside money in your budget every month for car maintenance and repair. That way, when something needs to be fixed or replaced, you don’t have to use your emergency fund. That same goes for home repairs. You KNOW that eventually something on your home will need to be fixed or replaced, so make a line item in your budget for that too. Especially if you have an older home.
Let’s mention a few more things that we sometimes treat like emergencies that are NOT:
- Christmas: it’s always in December.
- Kids grow. Who knew?!? They WILL need new clothes at least once a year.
- Kids also go to school at the end of summer. Every year. So budget for those school supplies.
- If you have kids in activities, budget boatloads. Just because you forgot they get soccer pictures every year doesn’t mean it’s an emergency.
- Weddings, birthdays, and baby showers. Yeah, I know they might get sprung on you at the last minute, but they are still not emergencies. Again, having a “Gift” category in your budget is a great way to set aside money for those events that you know are coming and for those you don’t.
Budgeting for expected expenses and saving an emergency fund for unexpected expenses is the best way to begin to get yourself out of debt. That is because when you have a plan and are prepared, you won’t have to put these “emergencies” on the credit card.
“What type of account should my emergency fund be in?”
This questions usually comes up when people get their full emergency fund established. Having $1000 or $3000 in a regular old savings account is no big deal. But when we start talking about $10,000 to $25,000, people start to want to get fancy to try to get a better interest rate.
Stop. Don’t get fancy.
Your emergency fund should always be in something completely liquid, so you can access it very quickly. A savings account, money market account, or separate checking account is all you need. You should never put your emergency fund in a CD or ANYTHING that would charge you a penalty for taking it out before the term is up. You should not put it in annuities or mutual funds or life insurance or (heaven forbid) single stocks. Too dangerous and too hard to get to in a hurry.
Think of your emergency fund as your own personal insurance to cover you in the event of a disaster. And insurance doesn’t make you money; it costs you money. So your emergency fund does not need to be in an account with a high interest rate. It just needs to be accessible and safe. Remember, avoid the fancy.
This is going to be a hard sell. The emergency fund is a no-brainer; everyone knows it’s a good idea to have one. It’s going to be a lot harder to convince you to save for purchases.
In our culture of instant gratification, with information and entertainment available instantaneously at our fingertips, it has become insanely difficult for us to develop and mature the virtue of patience. But you need to do it in order to win with money. Because if you borrow money every time you have the desire for a new car, furniture, or electronic gadget, you will be in debt for the rest of your ever-loving life. If that’s ok with you, fine. Go be mediocre. But if you want be financially secure and become an amazing person with patience, wisdom, and integrity, learn to save money for the things you buy.
The Sinking Fund
When you want to purchase something (like a computer) or you know you will need to repair or replace something (like the roof of your house), all you need to do is determine when you need or want to purchase the item and how much the item will cost. Then, divide the cost of the item by the months you have until the purchase needs to be made. Voila, the result is the amount of money you need to save each month for the item.
For example: You want to buy a new computer for $1200. You have decided that instead of opening a Best Buy credit card like a dope, you will be patient and smart and save the money to buy the PC. It’s May and you want to buy the computer before you go to college in September. So you plan to get an extra job working in the Garden Center at Shopko for the summer, but want to know how much you need to make every month in order to have $1200 by September. $1200 / 4 months = $300 a month. Easy peasy, lemon squeezy.
Another example: You buy an older home with a roof that will need to be replaced within 5 years. The estimated replacement cost is $11,000. $11,000 / 60 months = $183 per month.
The sinking fund idea can be applied to almost any large purchase or yearly/bi-yearly expense: cars, furniture, property taxes, homeowner’s/auto insurance, etc. It’s even a great plan to use for Christmas saving. If it’s March and you want to save $700 by December for Christmas gifts, you need to save $78 per month in your Christmas fund.
Saving for Cars??? Blasphemy!
Are you one of those people who has just accepted the fact that you’re always going to have a car payment? Don’t be a fool! Try this sinking fund approach:
Save up $1000-$1500 and buy a beater. You may think this is crazy, but I bought the car I’m driving now for $1200 dollars and have been driving it for over 5 years. Yes, I’ve had to repair it now and then (alternator, water pump, etc.), but the total cost of repairs I’ve put into it ($2900) over the scope of those 60+ months plus the cost of the car ($1200) has equaled a total cost of $4100. (Again this does not include routine maintenance that would be done on a new car too.) That comes out to roughly $68 a month. That beats the national average car payment of $494 by a mile.
Anyway, back to how we were going to get you off car payments. Buy that beater I mentioned. While you are driving that paid for car, save up what you would have paid for a car payment. Let’s say you would have purchased a car with a below average car payment of $350. If you drive that beater for 10 months and pay that car “payment” to yourself, you will have $3,500 in your car fund and you’ll probably be able to sell that beater for what you paid for it. So now you can purchase a $4,500 car with cash. That’s a decent upgrade, isn’t it?
Let’s do that again for 10 more months. Again, you will have $3,500 saved and you will be able to sell that car for a little less than you bought it. You end up with around $7,500 to buy your next vehicle for cash. Do it ten more months and you can buy a $10,000 car for cash. And so on, and so on. In less than 5 years, you will be able to buy yourself a brand new car for cash.
Now some skeptics will read that scenario and say, “You’re still making car payments every month even though you’re paying yourself. All you’re really saving is interest. And if I can get a 0% car loan, then what’s the difference?” How about this? Let’s say in two years you get laid off and aren’t able to find a job for a few months. If you have a loan on that new car, you are either going to deplete your emergency fund (if you even have one) that much quicker making the payments or risk repossession if you can’t make the payments. If you’re driving a reliable paid for used car and have a few thousand dollars in your car fund to cover breakdowns, you’ll be just fine until you find a new job. Plus, once you reach a certain point in your car “journey” where you’re buying a new enough car that it will last reliably for a few years, you won’t have to continue to save every single month for the next car. Just save the first 10 or so months and then sit on that money until you’re feel like buying your next car. Or you could still save every month, but a lesser amount. It’s up to you.
The point is, if you are willing to drive a lesser car now and work your way up to a new car by saving and paying cash, you are going to save yourself thousands of dollars in interest and have immeasurably more financial peace without the risk having a car loan. If you want to see a fun video illustrating this method, click here and here.
3. SAVING FOR RETIREMENT
This post is much longer than I anticipated, so number 3 will be short and sweet.
You have to save for retirement. You just have to.
If Social Security is not bankrupt by the time you retire, the amount you get will still be much lower than the standard of living you will have been used to while you were working. If you plan to get a company, state, or federal pension, you MUST still save into a separate retirement plan. If your company goes bankrupt or mismanages the pension fund, that money is gone and you won’t ever see it. State and Federal pensions are even at risk for mismanagement and budget cutbacks. (Hello California.) The only completely reliable form of retirement money you can count on is what YOU save.
As far as what to put your retirement in, I will cover the most commonly recommended investment methods in another blog post. For now I will just say that I believe investing in single stocks is too risky and CDs are just dumb. I personally invest in mutual funds, but there are many other options available too. The best advice you can get is from an investment professional. But make sure you find a broker that will TEACH you about what you are investing in – not just TELL you what to invest in. NEVER invest in something you don’t understand just because someone told you to. Many of these “professionals” will just recommend you invest in what’s most profitable for them, not necessarily what is best for you. So choose your advisers wisely, and make sure they treat you with respect and patience and don’t pressure you into anything.
The moral of the story…
You. Must. Save. Money.
If you want to have any kind of financial freedom, peace, or stability, you have absolutely GOT to save money. Save an emergency fund, save for purchases instead of buying everything on credit, and save for your future. Because if you don’t, your life is going to be nothing but one long rainy day.