One of the most important things to focus on when building a home is the foundation. If you build on a poor foundation, it won’t be long before you start seeing cracks in walls, concrete, and bricks, and your home may not withstand the first storm that blows through.
The foundation for your financial plan is your emergency fund. Investing can be complicated, but your emergency fund should be simple. I’ve seen people get fancy with emergency funds—putting the money in annuities, life insurance products, brokered CDs, high-yield bonds, and whatever else the investing world can dream up.
The key to an emergency fund, however, is safety and liquidity. It’s there for one purpose—emergencies. For this reason, you need to be able to access all of your money quickly, and you need to know that it’s unlikely to drop in value for any reason.
There are few things that can derail a financial plan more severely than an emergency for which you’re unprepared. So, before we start looking at more complicated strategies, we must be prepared adequately in this area. Then, we’ll talk about my philosophy on saving money, and go into some tips to get yourself motivated to start building the savings you need.
What are appropriate emergency fund investments?
1. Money market accounts
Money market funds typically lend money on a short-term basis to governments and corporations and usually have low credit risk. In other words, we don’t normally have to worry about whether the borrower will have the wherewithal to pay us back. Because of this, money market funds are some of the safest investments available, and since you can access your money at any time, they are perfect for an emergency fund.
There are two main ways you can invest in a money market fund: a bank or a mutual fund. The money market accounts you might find at a bank also benefit from FDIC insurance, adding an additional layer of safety. Money market mutual funds can be found through a broker, and while not FDIC guaranteed, a quality fund offers a high degree of safety as well. But remember, it is always important to get the details before choosing a fund.
Some money market funds will give you access to the assets through check-writing privileges. Keep in mind, though, that there may be minimum check sizes, a maximum number of checks you can write per month, and a minimum account balance may be required. Because of these restrictions, it is not unusual to see money markets paying a slightly higher interest rate than other alternatives.
2. Bank savings account
While the interest rate on a standard bank savings account may not be much to write home about, the quick access and safety of these accounts can make them ideal for emergency needs. Be sure to read the fine print, though, because there may be limits on transfers and withdrawals.
3. Checking account
This is what I use for an emergency fund. I use two types in conjunction with one another. The first pays no interest and has no limits on the number of transactions I can do every month. The other is interest-bearing, and it has limits on transactions—but I don’t concern myself with transaction limits since it is meant only for sudden emergencies.
If I need money quickly, I have that ability. If I may need several smaller checks, I can do a larger single transfer to the “no-interest” account and write checks as needed. I will normally keep the amount that I may, and probably will, need over the next month in the “no-interest” account. And I keep the rest of my emergency in the interest-bearing account. Don’t forget that the interest rate is secondary to liquidity.
Longer maturities and higher return?
Some products promise higher returns when the money will be tied up for many years. A 5-year CD, for example, will usually pay more than a 1-year CD because access is more limited with the longer time period, and with limited access comes increased risk. What if interest rates go up while your money is locked up for multiple years? If that happens, you’re stuck with the lower rate and not able to reinvest your money at the higher rates.
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In order to get people to take the risk of having their money tied up longer, investment providers entice with higher rates up front. The problem is that these investments often drop in value if you need all your money back before they mature. For this reason, products with long maturities aren’t a good fit for an emergency fund. We don’t know when an emergency might occur, but Murphy’s Law would teach and warn us that it might happen at the worst possible time.
When an emergency happens, you won’t be worried about how much money your investment made, all you’ll care about is if the money is there and how quickly you can access it.
For this reason, I recommend keeping it simple for your emergency fund. The purpose of these accounts is fast access, not high returns.
How big should my emergency fund be?
People often ask me how big their emergency fund should be, and my answer is always, “How big of an emergency might you have?” Could you lose your job? Could a slowdown in your business (if you have one) cause you to have to pay salaries for an extended amount of time with little or no revenue? Think of the coronavirus meltdown and the effect that had on small businesses. What if you become disabled and unable to work? What if the roof starts leaking or the car breaks down?
A common rule of thumb in the financial world is to have three to six months’ worth of spending in an emergency fund. Disability policies often have a ninety-day elimination period before benefits are payable. That means you must wait ninety days after you become disabled before the benefits will kick in. It may be another month before the first check arrives. Social Security has a disability benefit as well (if you are eligible), but it has a five-month wait, and you may have to hire a lawyer to get those benefits.
For many people, getting that much cash together can be a struggle. You may have to work up to it. When my wife and I first started out, we started a discipline of paying off debt and saving as fast as we could at the same time. I’ve heard people say, “pay off debt first, then save.” For us, it felt better to have a dual goal.
I felt much more determined when I was fighting a battle on two fronts at once. I liked the idea of knowing that, once my debt was paid down, I was able to look at a bank account with some money in it. It gave me a good feeling knowing that I would be less likely to go back into debt with that cash sitting there.
I know that the math favors the reduction of debt first, along with the interest that usually comes with it, but money isn’t always math with me. Psychology also plays a key role. Depending on the amount of debt and the ferocity with which you attack it (if debt is even an issue), the additional interest payments might be a small afterthought.
Getting determined
At this point, it’s a good time to talk about how I think about money, in general, and how to get laser-focused on reaching your savings goals.
One of my favorite books as a new financial planner was The Richest Man in Babylon by George S. Clason. It is a fictitious story of a Babylonian character who teaches principles of financial success through a series of parables. The book’s lesson on why we don’t save more and its insight on how to change our thinking deeply impacted me.
Clason points out how all the rich man’s “students” had different jobs, and therefore had different incomes, yet they all ended up with the same financial outcome—they were broke. I like to describe it this way: If one person makes $30,000 per year and someone else makes $35,000, then the one that makes $35,000 should be able to live at the same level as the one making $30,000 and save $5,000 per year.
There is always someone that makes less than us. How is it that so many of us make different incomes but end up with the same outcome—nothing left over for savings? Money is like a gas—it expands to fill up the container it’s in, no matter the size. In the same way, I find that, if left uncontrolled, people will spend all the money that comes in. This is a sure way to stress.
The only way out is to “pay yourself first.” You pay your cellphone bill, your auto insurance, and your food bill…. Now it is time to prioritize the payment to YOU Inc. You must live below the level of income that you make.
In order to help people prioritize saving, I often set up bank drafts for them. Some find it helpful to take money from their checking account every two weeks, or however often they are paid. The thinking is, If it’s gone, I won’t miss it. So, make it like a bill. Before you know it, the financial stress in your life will be drastically reduced.
We have now laid the foundation of the financial plan with the emergency fund. This answers the question: where do I start? We must have our risks taken care of first. I know it can be hard seeing that amount of cash sitting there without much return, but without a proper foundation, higher-returning investments can come crumbling down with the first threat.
With your foundation set, your well on your way to a great financial plan.
By Paul Winkler
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