As I alluded to with one of my previous posts, it seems pretty important to have some level of “cushion” of savings that can insulate us from the stress/worry of not having enough money to handle unexpected circumstances in life. So now that I’ve understood and agree with the necessity of building up some savings, where do I save this money? As it is with so many things in personal finance, there are so many ways to approach this. While perhaps there is one optimal method for each person’s situation, I’ve been learning that getting the specifics “right” isn’t as important as just doing it – “save now and tweak as you go” seems to be a better option than “don’t do anything until you’ve worked everything out perfectly.”
The way I’ve been experimenting with how to save money for our family has been an amalgamation of education about different savings vehicles, deciding what makes the most sense for each financial goal we have, and automating the allocation. Though this works for our current situation, I don’t think it’s 100% optimized yet, and I’m sure I will continue to make tweaks as I go.
Types of Accounts
There are tons of resources on the web that describe the different types of accounts available for storing money, as well as the strategies, pros, and cons about how to best use each type of account. While some of them may provide opportunities for the money to grow, others may not. As I began to compare the options available for where to put this extra money, I realized there were a few values I needed to consider:
Liquidity: In order to cover the cost of emergencies, I need the money I’m saving to be easily accessible (liquidity = how easy it is to access the money in an account or asset). After all, if I have to pay for a flat tire, I need to make sure that we have the money saved and readily available so that we don’t go into debt or incur fees paying for the tire. Checking, savings, money market savings, and credit union accounts are very liquid; CDs, bonds, sometimes stocks/mutual funds, retirement savings, and gold necklaces are not.
- Potential Returns: Not all accounts will make money on the money that’s put into them. If I were to store all of my savings in a jar in my house, it will never increase in value on its own – the only way for that money to grow is for me to put more money into the jar. Likewise, most checking accounts do not pay out any interest; if they do, the rate is typically ridiculously low, like 0.01% (which means that for every $100 in the account I would get 1 penny in interest). Standard savings accounts at most major banks aren’t doing much better right now – I think the interest rate is typically around 0.05%. Credit union savings accounts offer slightly better rates – right now my credit union pays 0.5%. And there are some high-interest savings accounts available (typically online banks since they don’t have to pay as much overhead). I use an online bank that pays close to 1% in interest. Money market savings accounts are also hovering around the 1% mark at many online banks. Bank certificates of deposit (CDs) and bonds pay a bit more in interest but are not liquid. Putting money into real estate investments has the potential of growing money, but all the money put into that property is definitely not liquid. Investing in the stock market still remains the best option available for growing money passively – but it’s not without its own caveats.
Principal Loss Risk: Another factor when it comes to savings is considering how likely it will be that I could lose the money I’ve put in – after all, if I’m going to be stashing away money for a rainy day, it would really suck if something bad happened and the money in my rainy day fund was completely gone. Banks are typically insured by the FDIC and credit unions are typically insured by the NCUA, so that even if the bank or credit union went out of business, I would still get my money back. Bank CDs are similarly secure, I think. Money market savings accounts work the same way, from what I can gather – but money market mutual funds do run the risk of losing principal value (the money I’ve put in), even though the risk is extremely low. Bonds can be slightly risky as well – the “likelihood of default” (i.e., not paying back the principal amount) for the bond determines the risk for principal loss (for example, U.S. Treasury bonds are extremely safe because if the U.S. is going to default on its loans – a bond is a loan you give out to an entity – we’ve got bigger problems, but a “junk bond” might be more likely to default). On the flip side of things, hiding cash in a pillow or mattress or in a jar/safe in your house is riskier than you might think, because if there was a fire or a robbery or if you threw out the pillow/mattress on accident, that money is gone and won’t be replaced – so if that happens you’d lose 100% of your savings. Individual stocks are pretty risky too – because there’s no way to predict what the stock price is going to be at the moment when you need the money, it would suck if you needed that money immediately after the stock market crashed, or perhaps that one particular stock tanked. Mutual funds and a diversified stock portfolio helps spread out that risk a bit, but even there I don’t know of any advisors who recommend putting all of their emergency funds into the stock market. Bond mutual funds and exchange-traded funds can be similarly risky as stock mutual funds and definitely can be riskier than owning individual bonds, because the value of the fund is tied into the relative value of all the bonds that are owned within that fund (which is inversely related to federal interest rates), rather than just the risk of default within a single bond.
Inflation Risk: One of the things that I’ve come across, sometimes as an afterthought, is this concept of inflation – the idea that the price of goods and services increases over time. For example, when I was in medical school, a 24-pack of Dr Pepper would typically go on sale for around $5.00-$5.50. Now, $7.00 for that same 24-pack of Dr Pepper would be considered quite a bargain. Basically, every dollar I have now is going to buy me more stuff now than those dollars will most likely buy in 10-20 years. Google tells me that this “rate of inflation” fluctuates but is typically around the 2-3%/year range (it’s ranged from around 0-4% in the past 10 years). Well, if I have my savings in an account that grows only 0.05%/year (or nothing at all if I hide the cash under my mattress), that same amount of money is going to afford a whole lot less in the future. Because of this perpetual increase in inflation (deflation is supposedly a bad thing from what I understand), that emergency savings fund may need to continually grow – either on its own from interest earned/investment growth or from my own contributions – or risk not being enough for expenses when we might need that money.
- Time Risk: Time is another important factor to consider. This concept is even more important when it comes to investments. I learned that time can smooth out short-term risks – so if a particular investment is really risky in the short term, that risk spread out over the course of 10 years might make it far less risky. Longer amounts of time decrease the risk of principal loss risk in investments (no change for mattresses, of course). Conversely, the longer the timeframe, the less liquid the money is and the greater the risk is for inflation to decrease the value of the money in the account.
My Personal Savings Strategy
What I learned about these different accounts was that every type of account has its pros and cons. There is not one account that is strong in everything, but each type of savings “account” can play a role in mapping out a strategy for handling this emergency savings issue.
This is where my strategy (for better or for worse) differs from a lot of the financial advice that’s being put out there for the public. I don’t think I’m smarter than these very successful gurus, but my approach is customized based on the different goals or purposes we have for the money we’re saving. Perhaps I’m doing it wrong, but I think the approach I’m taking to our situation helps us save as efficiently as possible. I don’t think this strategy works for everyone, but this is how we have our money organized. I think my strategy most strongly mimics the strategy advocated by the guys at Listen, Money Matters!, but because our priorities and plans are slightly different, it isn’t a perfect imitation.
- Main account (checking): Everyone handles their income and expenses differently. Personally, I like having 1 main checking account that receives all of my income and is linked to all of my savings and expense accounts. I don’t consider this main account our “emergency fund” account; it’s more like a hub where I allocate the money we make to all of the different buckets/accounts we have – credit cards, savings accounts, investment/retirement accounts, loans, etc. I try to keep a minimum balance of $1,000 in this account though, just as a cushion in case we have a major purchase and to offset the delay it takes to transfer money into the account from our savings. While $1,000 may be far too much money for some people to keep in their checking account (it wasn’t that long ago that my minimum balance was around $50-100), but we have a lot more expenses and responsibilities (for example, my student loan minimum payments are around $1,700/month), so we need more of a cushion. I suppose that $1,000 buffer counts towards the “entropy happens” fund.
- 2-3 months of living expenses (high-interest savings): My goal is for us to keep 2-3 months of our monthly living expenses (which includes all loan payments, insurance payments, food, entertainment, etc.) in one high-interest savings account that would take care of us in the event we both lost our jobs or something equally devastating. Ally Bank currently has online savings accounts with an APR of 0.99% which seems to be one of the highest around. I can transfer money out of the account 6 times per month (no limit on deposits), and I keep this money separated from other savings goals (such as money that we’re saving for house renovations/decorations, children, vacations, etc.). While some people will use one big savings account for all of these different savings goals, I’ve found that it works better for us to keep all of these things separate so that we don’t end up overspending or undersaving in one category and cripple ourselves when an emergency does arise. Once we’re debt free, our monthly expenses will drop tremendously and I figure by that point I’ll be able to stop funding this account. Although this is a bit more than what we actually spend per month, I would say that keeping about $20,000 in this account would be a good idea and be easily accessible for any periods of lower income.
Our “escape plan” fund (high-interest savings): Like I alluded to before, we’re not really planning or hoping to lose our jobs, but I think it would be pretty stupid of us to think that our jobs are 100% secure forever. While we will hopefully have 2-3 months of unemployment contingency funds to tap while we are looking for jobs, there is still a distinct possibility that if one of us loses our jobs we may have to move (especially if I lose my job for some reason, since my non-compete prevents me from practicing in this state for 3 years). Family issues could always force us to relocate as well. Because that 2-3 months of living expenses doesn’t cover the cost of applying for jobs/traveling for interviews, selling our current house (including staging if necessary), house hunting, moving expenses, applying for medical/nursing licenses in a different state, and so many more expenses, I am keeping a separate “escape plan” fund that we can tap for these types of expenses. While hopefully many of the job interviews will be either reimbursed or covered by the practice I would interview at, I can’t count on that as a certainty. Additionally, there may be other expenses that aren’t covered, so it becomes extremely important that we have enough extra money saved up so that we don’t end up being stuck in credit card debt or some other kind of debt if we end up having to move. The amount we need in this fund is much harder to gauge, since the expenses will be largely dependent on the number of places I may need to travel to for interviews, how far we need to move, how long it will take to sell our current home (and get it ready for selling), buying or renting where we are moving, the costs of applying for our licenses in that new state, etc. I think the starting goal is $15,000 but I could definitely anticipate needing in upwards of $25,000 if there are a lot of surprise costs, such as unexpected repairs to the house or high closing fees.
- Our “life disaster” fund (taxable investment account): Because this situation is not very likely, I feel very comfortable taking a little bit more short-term risk with this money. As I was setting up these accounts, I realized that while I am steadily funding each of these accounts, there was quite a bit of money we’re setting aside that we will most likely not ever have to touch for at least 5-10 years (or longer). Because I know we will fund all of these other accounts eventually (hopefully within the next few years), I also want to take advantage of the power of compounding returns that comes from long-term investment in the stock market. I created a Betterment account, which is a cool roboinvesting company that invests my contributed money into low-fee index exchange-traded funds in the stock and bond market, which, on average, will yield far better returns than simple savings accounts. Of course, because of the short-term risks inherent in stock/bond fund investing (that “volatility” thing), I would rather plan for this money to grow as “only if we really needed it for something awful.” Betterment hides the complexity of purchasing multiple investment funds by doing its own automated asset allocation – so all I have to move a slider between what percent I want invested in stocks and bonds to determine the amount of aggressiveness I want in my savings account (they make it very easy to set up multiple goals too). Betterment seems to be pretty liquid though, and its automated investing strategy minimizes the taxes that can come from withdrawing money from the account – it’s a lot like an investment account disguised as a savings account. While we’ve been building our own portfolio of investments (both in taxable accounts and various retirement accounts), Betterment savings will probably serve as a place where we can put long-term money for more aggressive growth that will help cover those truly disastrous emergencies. I don’t have a specific target amount right now, but I figure it’ll be where we’ll stick most of our “6- to 8-month emergency” money. As we get closer to those target amounts, I’ll probably dial back on those contributions and start doing more with our other investments.
Automating The Allocation
Since this article is really supposed to be spelling out the details of my strategy for our emergency savings, I didn’t really spend time discussing how I’ve set up our other investments, insurance plans, health savings accounts, etc. Perhaps I’ll cover those topics at some later date.
The final cog in this setup is automating everything so that I’m not having to think about it at all. Even though I’m very OCD and somewhat obsessed about watching our finances right now (especially given all of my student loan debt), I know that by automating the transfers for these savings accounts I won’t be tempted to skimp out on saving one month to buy a new mandolin or whatever else I want.
Since I get paid every other week, I set up my accounts to automatically transfer a certain amount of money from my main checking account to each of these savings accounts corresponding with my paychecks (so I don’t run the risk of over drafting on my checking account), and not touch the accounts at all. I think that the automation is that final piece that speeds up the process of saving, and though I may make some adjustments in the contributions from time to time to account for fluctuations in our income, we can still see those accounts slowly and steadily grow until we are a lot more financially secure (not that financial security is our only aim in life, but it is very helpful).
What are your strategies and ideas for saving for emergencies? Leave a comment and start the discussion!