Our Below Your Means Basics series this week deals has been focused on looking at your finances from a perspective of your Net Worth. We started the series discussing Income vs. Net Worth, and then took a look at debt. Today, we’ll be taking about different mechanisms of savings and ways to examine your savings in light of growing your overall net worth.
You may be thinking that day you are dividing up the different kinds of money you have saved into categories is a great day indeed – and one far away from now. But the truth is that everyone, regardless of their current financial situation, can benefit from looking at their savings, and starting to save.
Types of Saving
There is near-universal agreement that you should start saving for retirement as soon as possible, and this advice is usually accompanied by some sort of chart showing how the $20/month you put away now will turn into a bazillion dollars sometime in the future. Those charts are right, of course, and you should start saving for retirement as soon as possible, and taking advantage of the various tax benefits of doing so. Consult a tax adviser for more details, or check out Saving for Retirement at our favorite online legal resource, Nolo.com.
We do have some concerns with the idea of saving for “retirement”. For one, the whole idea of saving for retirement is really created by the tax code. It came about at a time when people thought they would stay with the same employer for most of their lives. Really, when you talk about saving for “retirement” you’re talking about saving for “old age.” Nowadays many people have multiple careers and employers are just as eager to hire contractors as they are hiring employees.
If you focus on building your net worth instead of saving for retirement, then the idea of retirement starts to get a little odd. It begins to sound like you are going to do something you hate until you hit some magic savings goal (and age) at which point you get to stop doing that hated thing, and start doing things that you love. But with sufficient net worth, and a focus on using your money as a tool for your happiness, you can come up with ways to have an income doing something that you love, because maximizing your income at any given second to afford a life that doesn’t make you happy… well, you aren’t doing that any more.
So, by all means, keep putting money away for your 60’s and beyond. We’re not saying you won’t be happy that you did. But, don’t make that the only thing you are saving for.
The Emergency Fund
In our minds the Emergency Fund is the single best kind of savings you can start working on right away, because it will make a difference in your life very quickly. There are many different ideas about how large your emergency fund should be, but they tend to fall within 3-6 months of income or expenses. Since we are looking at our financial life from a perspective of net worth and not just income, we’re going to recommend you start with 3 months of expenses and then work your way up to 1 year of expenses.
You might be saying: One year?! That’s a lot of money! And we answer: Precisely! It is a lot of money, and having a year of your life in the bank is tremendously liberating. But even before you have 3 months of expenses in the bank, you’ll see benefits:
- Most importantly, you won’t have to use your credit card every time the unexpected happens. This one change will make a profound difference in your financial life. It will lift your spirits and confidence. And, there won’t be an interest charge associated with the unexpected.
- You can self-finance variables in your budget. By self-finance, we mean you won’t have to use your credit card. This time, it’s for things that are expected but harder to plan for, like the life insurance bill coming due this quarter and knocking you off your monthly routine.
- You can afford to carry less insurance. When you have an emergency fund, the idea of paying a lot of money for a $250 deductible isn’t as appealing. Again, this is a result of net-worth thinking rather than income thinking. If you don’t have an emergency fund, then you’ll decide the higher monthly insurance bill is a good buy because you can’t afford a $1,000 deductible if your car gets hit. But if you have that money in the bank, then saving money on your insurance gets easier.
- You can start to seize opportunities. Much like long term debt, you should limit this to opportunities that help you build wealth. For example, you have the opportunity to interview for a new job that pays 120% of your current salary, but your future employer requires a certification that you don’t have. You can afford to take 2 weeks of unpaid leave (assuming you can work it out with your current job) to go get the certification.
Once you have one year of expenses in the bank, your life will be very different. You will start to value and see things differently. You will be on very secure footing indeed.
Every debt you carry has a principal on which you pay interest. The principal is the money you owe, so in a sense, paying it off is a form of savings. Once you have debt there is no use beating yourself up about it anymore. You should, however, focus on getting that principle paid off as soon as possible. If you have the income, and can cut your spending enough, you should save for retirement, an emergency fund, and pay down the principal on your debt. Experts generally agree that you should pay down principal first on your credit cards and second on your car loans. There is disagreement about whether or not you should pay off your home early, but we certainly wouldn’t advocate it unless you have a solid emergency fund and you are on a good plan for retirement.
As far as paying down your credit cards – how much is enough? The answer here, as with many of your budget decisions, will come from your values and goals. Having said that, you should also use a credit card repayment calculator (CNN Money has a good one here) to get a clear understanding of how much interest you are paying on the debt. Some financial advisers recommend you pay down your highest interest rate card first, and then move on to the next highest rate, etc., until they are all paid off. Others say that you should pay off the one with the lowest balance to give yourself a confidence boost and eliminate a creditor.
We personally recommend that, if possible, you consolidate all of your credit card debt onto a single new card that has as low an interest rate as you can get. If you can’t get a new card, then consolidate them as much as possible on the lowest card you have. Cut up the high rate cards. Check out the Helpful Links at the end of the article for more on paying off your credit cards. You might also consider refinancing your credit card debt with a lender like Prosper.com or LendingClub.com. We are affiliates of each and recommend them both.
Short Term Savings Goals
Short term savings goals are a great way to handle projects (leisure or otherwise) that aren’t part of your monthly budget. Let’s take two common examples: Gifts (especially around the holidays) and Vacations.
The credit card method of handling gifts or vacations is to have a rough idea of what you are willing to spend, and then to go out and probably spend more. Afterwards, you finish the vacation (or wrap up December) and cringe when you see the amount of debt you racked up.
Having a savings goal means having a budget. In this model, in January (or whenever you next review your budget), you decide how much you are going to spend on vacation or gifts. Then, work it into your monthly budget. Let’s say a family of four decides they are going to spend a total of $700 on Christmas. $500 will come from the household budget and will be used to buy presents for friends and family. The spouses decide that they will have a $100 limit on gifts for each other, which will come out of their own personal spending accounts.
Now, the family budget needs to be adjusted to make room for $42 of savings per month, which will yield $500 by the end of the year. Each spouse also needs to squirrel away a minimum of $8.33 per month from their personal accounts. (This is the kind of savings that the envelope method is great for). Now, the spouses get together and split up the $500 pot between the kids, grandparents, other family members and friends. They revisit the budget on a regular basis to see (1) that they have actually saved enough, (2) that their spending is in line with their plan and (3) to reallocate their budget based on new information (they got Suzie’s present cheaper than they expected so they can afford Grandma’s more expensive gift).
Vacation spending works the same way. The family vacation budget is set, the savings happens BEFORE the vacation, and away you go.
Once you are saving regularly, and have budget that keeps you from spending more than you earn, you are well on your way to building wealth. We’ll talk more about that next time…