what is the most important goal to save for?

We’ve only got so much money to save, so — what’s the most important goal to save for?

Is it college? After all, tuition ain’t cheap now, and it’s rising at an average of 7% per year — best to start saving now!

Or is it retirement? Financial advisors are fond of saying, “retirement first: you can borrow for college, but you can’t borrow for retirement.” Sound words of wisdom, from my point of view.

Or is it paying off high-interest debt? That seems a slam-dunk: it’s hard to beat 14.98% (the current national average, according to creditcards.com) guaranteed return on investment.

But even before that, there’s one thing that I would recommend you save for first: if you don’t have it, you should scrimp and save until you get it. It won’t take very long, and it’s the single best thing you can do for your financial well-being:

One month of income in your checking account at all times.

Or one month’s expenses, if you prefer, and you don’t have a zero-based budget set up. Regardless, you want that money there, in cash, before you get your paycheck, not doing anything fancy. Why?

A buffer is a shield between you and Life.  Let’s say you’re looking to turn your life around, ready to dig out of debt and start saving for the future. You allocate every penny you have to your debt…and then you get hit with an unexpected expense, because you haven’t been budgeting for that long. Where does the money come from? Your credit card – or worse, the bank, with a nice overdraft fee on top of it. Dave Ramsey calls the one-month buffer a “baby emergency fund”. He also calls it (and its big brother, the 3-6 month cash reserve) “Murphy repellant”. He says that bad stuff just doesn’t happen as much, when you have a buffer. Now, I don’t know that I agree with that, but I do agree with this: bad stuff feels less bad when you have a cushion in the bank.

A buffer helps you sleep at night.  A one-month buffer is the single best thing you can do to ease your financial worries. Why? Because whatever happens, you know you have at least whole month’s worth of expenses to help you tackle it, so you can afford to just handle things as they come and figure out the long-term repercussions during your monthly money check-in. And let’s face it: stuff happens, all the time. Not just big things, but little things, especially when you’re in a family, and especially when you’re just starting out on the whole budget thing. But when you have a buffer, you sit down to review your budget each month, look at how much you overspent, and take that off the top when you’re budgeting for next month. Your buffer is replenished, and you move on. No stress, no muss, no fuss, just constant forward motion, little by little.

Saving up for a buffer doesn’t have to be sustainable. Now, I just talked about constant forward motion, little by little, but that comes after you establish the buffer. That’s the good thing about it – compared to other things you’ll be saving for, it’s relatively small. But it’s very vital. So when saving up for it, you can go crazy, unsustainably crazy. You can work overtime, or take on a second, part-time job. You can cut your expenses drastically.  You can sell stuff on craigslist. (Heck, Liz sold her last car on craigslist, did it nearly instantly, and for more than trade-in or Carmax.) The folks at YNAB (the world’s best budgeting program) say that according to their numbers, it takes an average of four months for people to save up a one-month buffer. That’s not too long. And once you’ve hit that goal, you can relax. Start spending again, stop working so hard.

And you’ll have a motivational boost that comes from a quick win, to keep you going through the next priorities, which may take a bit longer!

what will you wish you had saved for?

As you’ve probably begun to notice, here at financialgeekery.com I’m big on questions. Today’s question: what will you wish you had saved for?

The wonderful thing about money is that it’s so very fluid; it can — quite efficiently — be turned into almost anything! But that’s not all; it’s also fluid in time. You can borrow money from the future to pay for the present, or you can save money in the present to pay for the future. (If you’ve figured out a way to move money to or from the past, let me know in the comments section.)

Of course, rare is the person who figures this out when it can most benefit them. When I was a “freshout”, having just graduated college and making more money than I could imagine (something south of $40K a year, if I recall correctly) at my engineering job, I didn’t really pay attention to my money. I had some vague notions about saving for retirement, but for the most part I just let my money go where it wanted to. Now that I’m older and actually have to watch my finances like a hawk, I wish I could go back and knock some sense into Young Me. “You idiot! Why are you spending money on all this junk you don’t care about? What about that house you’re going to buy in 2001, or the emergency fund for the kids you’re going to have in 2006?”

Sadly, we can’t do that, and there’s no use wringing out hands over the past. You can, however, ask the question: “in the future, what will I wish I had saved for?” Of course, we don’t necessarily know that — but someone else might. Specifically, your friends who are ten, twenty, or thirty years older than you. In fact, a couple years ago, Ramit Sethi asked them for you. The answers are not terribly surprising…and they’re worth considering. I’ll resist the urge to summarize here: go take a look yourself. Don’t just read the big speech bubbles — check out the graphs and see what might be in your future. Your future self will thank you!

While we’re sitting here chatting, tell me, for the benefit of the younger folks in the audience — now that you’re older and wiser, what do you wish you had saved for?

savings, continued: but what about cd laddering?

CD LadderA fellow financial geek asked a very good question about my savings post: what about CD laddering? Fair question!

CD laddering is a technique used to get more of the upside of long-term CD’s (higher interest rates) while mitigating the downside (locking your money up for years at a time). The idea is that instead of putting all your money into one large long-term CD, you build a “ladder”, breaking up your money into small chunks and working your way up from, say, 3-months to 5-years. Once you’ve reached the top of your ladder, the idea is to have a 5-year CD maturing every three months; if you need the cash, you have access to (some) of it every three months, and if interest rates suddenly rise, you can slowly reinvest your maturing CD’s at the new rate.

It’s pretty geeky, so a site called “financial geekery” would be remiss if I didn’t talk about it. I’ll get into the details of how to set one up a little later. For now, though, I want to talk about why I didn’t mention it in my last post.

First off, as I mentioned, if you don’t already have a ladder set up, now is not the best time. 3-, 6-, and sometimes even 12-month CD’s generally are running worse interest rates than an online savings account; even when you get up to 5-year CD’s, the advantage over a savings account is only 1%-2%. If you’re not looking at putting away a large amount of money, it’s really not worth the hassle. Also, while spreading out your money in a ladder is certainly better than plunking it all down in a single 5-year CD in terms of interest rate risk, it’s still pretty much a given that interest rates are going to go up, as there’s no room for them to do otherwise!

Finally, make sure you consider what that money is for. If it’s an emergency fund, think hard about how much of it you’re willing to keep illiquid; if you had a 6-month emergency fund, I might consider putting 3 months in a ladder. If the money is for a long-term goal, like retirement or college savings, you’re better off investing in higher-risk/higher-return vehicles, like stocks and bonds (that’s a post for another time). If you’re saving up for something, rather than having a lump sum you’re putting down, then it’ll be a pain to add that to the ladder while you’re building it.

All that said, if you’re a geek like me, it’s a fun game to play. So if you have at least $10,000 to play with, and you’re almost positive you won’t need to touch more than 5% of it more than once every 3 months, then here’s how it works. It’s pretty straightforward, and the best way to teach is by an example. Let’s say you’ve got that $10,000, and you want to spread it out over 5 years.

Step 1: Start off with the following:

  • $500 in a 3-month CD
  • $500 in a 6-month CD
  • $500 in a 9-month CD
  • $2000 in a 1-year CD
  • $2000 in a 2-year CD
  • $2000 in a 3-year CD
  • $2000 in a 4-year CD
  • $500 in a 5-year CD

Step 2: 3, 6, and 9 months later, take the currently-maturing CD and invest it in a 5-year CD. This is the annoying part — if you don’t do this within a certain period of time after the CD’s maturity (the “grace period”), it will automatically renew. You don’t want the money from the 3-month CD to become another 3-month CD — you want it to be a 5-year CD! Put the dates in your calendar, preferably with automatic reminders (huzzah, Google Calendar).

Step 3: 12 months later, take the 1-year CD and re-invest it as follows:

  • $500 in a 3-month CD
  • $500 in a 6-month CD
  • $500 in a 9-month CD
  • $500 in a 5-year CD

Step 4: For the following 4 years, repeat steps 1 and 2.

Five years after you started, you’ll have 20 5-year CD’s, one maturing every 3 months. At this point, you can let it go on automatic; unless you need the money, when a 5-year CD matures, you can just let it renew — hopefully at a higher interest rate!

savings

So you’ve got some cash on hand that you’re not going to spend right away. It’s a nice feeling, isn’t it? Maybe you’re saving up to pay your property taxes at the end of the year. Maybe you’re looking forward to a cruise next summer. Maybe you’re about to get married. Whatever the case, you’re looking for someplace to stash this cash — someplace not in your checking account, nor under your mattress. With so many options — CD’s, savings accounts, bond funds, money markets — what do you do?

My short answer? Put the money in a savings account. Make sure it’s FDIC or NCUA-insured, though most of them are. Which one? Simple: whatever’s most convenient for you. I’m partial to ING Direct, because they have no fees, a competitive interest rate, and great customer service (in my experience), and they make it ridiculously easy to open targeted sub-accounts for each of your savings goals. But really, whatever’s most convenient for you.

For the long answer, let’s start by assuming that your baseline is an ING account. No fees, as I mentioned, and currently earning 1% interest. What else could you do?

Well, you could put the money into short-term bond funds, but that’s more risk than it’s worth. As of this writing, Vanguard’s Short-Term Investment-Grade Bond Index is yielding 1.68%. So let’s say you had a whopping $10,000 to sock away. That would get you an extra $68 per year over the ING account — less than $6 per month. And remember, bonds are not FDIC-insured, and hence carry risk. How much risk? Well, think on this — when interest rates go up, bond values go down, and interest rates currently have nowhere to go but up. I’m not saying you shouldn’t own any bond funds right now — quite the contrary — but I definitely wouldn’t look to them for short-term saving.

What about a money market mutual fund? No way. Their interest rates are awful. Vanguard’s Prime Money Market is yielding 0.06%. That’s right — less than one-tenth of one percent. That $10,000 would earn you a grand total of $6 for the year. Again, they have their place, but not in your short-term savings.

If you don’t need access, you could put the money in CD’s. I wouldn’t bother, though. A one-year CD might get you 1.3% or so. Is 0.3% (in the above case, $30 per year!) worth the lack of flexibility? As for CD’s with maturities further out than one year, I wouldn’t recommend it, for the same reason you don’t want to put your savings into bond funds — you don’t want your money stuck in CD’s when interest rates go back up!

I’m sure you’re noticing the theme. The interest rates for just about any safe product are close to 1%, and you have to take pretty hefty risks to get anything above that. So take advantage of the lack of interest rate differentiation to look at other factors: convenience, customer service, ease of use, no fees. You’ve got better things to do with your time than to go chasing rates.