By Jason Van Steenwyk
There are lots of articles out there about how to save money by looking for bargains and clipping coupons. But here at MIBMoney, we figure you’ve already figured most of that stuff out. There’s a lot less written, though, about what to do with that money once you save it! This article is designed to be a closer look at the importance of savings, and what to do with yours.
The Importance of Savings
Aside from possibly keeping up your car, medical and life insurance premiums, the first step in any good financial plan is this: Cash in the bank. You need to build an emergency fund – and protect it for emergencies. Consider: A recent Harris poll found that nearly one in three Americans have no retirement savings – and one in five have no significant emergency fund whatsoever. What’s worse, the number is rising. Harris is reporting a significant increase in the percentage of savingsless Americans since the last similar poll was taken, just 18 months ago.
That’s a lot of Americans living paycheck to paycheck. If this is you, you are perhaps one or two paychecks away from being homeless – living on someone’s couch, or worse. What’s more, with more and more employers doing financial background checks, an eviction on your credit report could make it much more difficult, in some industries, to get back on your feet in the event of a layoff. And the layoffs are still coming.
Enter the Emergency Fund
The most reliable insulation against sudden income shocks is cash. Don’t rely on credit cards to see you through the rough patches: Banks have a way of cancelling your card just when you need it most. Home equity? Again, don’t count on it. It could take days or weeks to process a home equity loan. And if you’ve just lost your income, you could get declined.
Instead, you need cash. Money that you can get your hands on right away, to pay for that auto repair, or to pay your rent or mortgage for weeks or months while you’re looking for work.
How Much Emergency Fund Cash Do I Need?
Honestly? More than ever. In the old days, it was usually enough to have three months’ worth of expenses in the bank. But stop and think: According to data from the Bureau of Labor Statistics, the percentage of unemployed who have been out of work for six months or longer has exploded by 400 percent since 2008. This means that three months isn’t a target, anymore. It’s the minimum. The reality is that unless you are a very junior level worker able to fit in almost anywhere, a realistic emergency fund should be able to support your basic expenses for a minimum of about six months, according to Thomas Jensen, a fee-only financial planner in Portland, Oregon.
For many of you, unemployment insurance can help cover part of the gap. But not everyone qualifies. If you have a spotty work history already, if you are self-employed, if you are a 1099 contractor, if you are a seasonal hire or a pure commission employee, don’t expect to be able to fall back on unemployment insurance. You are on your own. (Fortunately, you’re self-employed! You don’t need to rely on anyone else, in theory. Unemployment claims for the self-employed are usually more trouble than they’re worth. Go find some new customers!).
Ok, I’ve saved. Where do I put my money?
The most obvious place? Under your mattress or in a coffee can in the house. This has the advantage of being readily available. Unfortunately, it has the disadvantage of being readily available. Your kids can find it and steal or lose it, for example. Or thieves can walk away with it. Meanwhile, it earns no interest, and slowly gets eroded by inflation.
Our advice: Don’t rely on cash on hand, other than for a small portion of your emergency fund.
Notice I wrote “savings account” instead of “checking account.” This is because emergency money in a checking account tends to get spent on non-emergency things. Even with the best of intentions, keeping your emergency savings in the same account as your checking account money can hang you up if you are the victim of identity theft and a thief zeros out your account. By keeping your savings account money segregated from your checking account money, you can help ensure that in the event of identity theft, a bank error, or even an unexpectedly large electronic draft, you can still put food in the refrigerator or gas in your car while you work things out.
Savings accounts generally also pay a somewhat higher interest than checking accounts (though it won’t be much, these days.) More importantly, though, any money you keep in a bank or credit union savings account receives FDIC insurance (CUFA insurance for credit unions) of up to $250,000 per account holder. This should be sufficient for most emergency funds, we think.
You can also generally access this money pretty quickly by transferring it into your checking account, or making a withdrawal from a bank (though you may have to wait until a week day before you can physically withdraw more than the ATM limit, typically of $400 per day).
Certificates of Deposit
These are great for larger emergency funds, because they also receive the FDIC guarantee. They typically pay more interest than either the savings account or checking account. But they are better suited for people who have already established an emergency fund and want to commit a relatively large amount – say, $10,000 or more – to a very safe savings vehicle. That little bit of interest comes at a price: The bank wants to be able to lend it out. If you need to withdraw your money before the CD matures, expect to pay a penalty for early withdrawal. Typically the penalty is six months’ worth of interest, though your mileage may vary. So CDs aren’t as liquid as savings or checking account funds, nor even money markets (see below)
A money market is basically a really, really conservative mutual fund. The fund company buys a whole bunch of very short-term debt, including commercial paper, short term treasuries, investment grade municipal bonds, and the like. They manage the fund to maintain a net asset value of $1 per share, day in and day out. Anything over $1 per share typically gets credited as interest, but you can reinvest your interest back into the money market fund (it’s taxable as income, just as CD and savings interest is).
You usually get a slight boost to your interest payments with a money market. And many money market funds will give you a checkbook, allowing you to write a very limited number of checks against your money market account. You may, for example, be restricted to one or two check transactions per month, so you may want to use your transaction to transfer a significant sum of operating money to your checking account, rather than pay one or two smaller emergencies at a time.
The downside of money markets? They are not FDIC insured. So if the company goes bust, you will be left holding the bag. Also, money markets can, theoretically, lose money, dropping the below $1 per share. This is extremely rare, but it does occasionally happen. Money in a money market fund is pretty safe, but it isn’t risk free, by a long shot.
You may be able to borrow against a life insurance policy. The insurance company knows you’re good for it, because they know you’re going to die eventually. If you never pay a cent, they will take their balance, with interest, out of the life insurance death benefit they pay your beneficiaries.
If you have a life insurance policy with a cash surrender value, you can consider it part of your emergency fund. Some life insurance policies pay dividends that are much greater than CD and money market interest rates – tax free. Be advised… if you surrender your policy altogether, you could be liable for taxes on any gains within the policy. Usually, it’s better to keep the policy in force to avoid the tax and borrow against it rather than surrender it entirely.
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