Rainy Day Savings: The Fundamental Pillar to Any Financial Plan
IS IT IMPORTANT TO HAVE AN EMERGENCY SAVINGS FUND?
An emergency fund is extremely important. In fact, a 3-6 month cash cushion is fundamental to having a sound financial plan. Without one that person is forced to borrow from high-interest rate credit cards to cover significant financial surprises. When that happens, a common side effect is reduced savings towards retirement and college, as well as delaying other important financial goals. In more extreme cases, retirement accounts are raided in order to cover a significant expense.
A much more enviable position to be in is when someone can simply write a check when the rainy day arrives. Having the ability to do so is much less stressful than being forced to borrow at double-digit interest rates. The root of the problem is most people think that the rainy day financial surprises won’t happen to them, which is rarely (if ever) true. You should bank on them. Literally!
WHAT IS THE BEST WAY TO PRIORITIZE SAVINGS?
Aside from paying down any unsecured debts and saving up to your company match for retirement, building an emergency savings fund is easily the next highest priority for our clients. You never know what kind of curveball life is going to throw your way—losing your job, the roof needs to be repaired, you need new tires on your car, your kid broke their leg, etc. Once people take a step back and think about it, the number of financial surprises that can happen in any given year can mount quickly.
With that in mind, it a lot easier to prepare for those situations when you are in a sound financial position than to react to it after the fact. This is why we emphasize the importance of saving for a rainy day. Credit card debt and personal loans carry such high-interest costs that a person's net worth will go the wrong direction if they aren't aggressively paying down those debts. Unfortunately, in order to do so, it means other financial priorities need to be put on the back-burner. Not to mention, the overhanging burden and stuck feeling people get from being indebted. Being in such a position is when financial stress becomes real.
HOW DO YOUR EMERGENCY SAVINGS FUND NEEDS CHANGE IN YOUR 20S, 30S, 40S, AND 50+?
An emergency savings account is needed at all stages of adult life. Younger people (20s and 30s) usually have fewer resources at their disposal, therefore, a target of 3 months worth of living expenses is more realistic.
Setting realistic expectations is especially important to ensuring younger savers don't get discouraged by setting too high of a target. On the other end of the age spectrum, we usually recommend that retirees keep 6 months of living expenses in savings because they are living on a fixed income. In addition, business owners and those living on a commission based compensation structure should keep at least 6 months of living expenses saved, and may even want to consider as much as 12 months to play it safe.
The bottom line is that the steeper the consequences and the higher the risks of needing to invade your savings, then the more that needs to be saved for when things go wrong. Sometimes this is easier said than done. Which is why achieving incremental progress is paramount to achieving progress. One strategy we often use with our clients is that every time they get a pay raise, they save an extra $100/month.
WHEN SHOULD SAVINGS BE LIQUID AND WHEN CAN THEY BE PUT IN CERTIFICATES OF DEPOSIT (CD) OR OTHER INVESTMENTS?
CDs are a good place to park extra cash for things like a down payment on a house in 1-2 years. However, we don't recommend them for an emergency savings type of situation because that money needs to be kept liquid at all times. The problem is that CDs have term limits. If the CD holder needs to tap into those funds they risk forfeiting their interest at a minimum, and in some cases might pay a penalty to the financial institution.
Rather, we prefer our clients to keep emergency funds liquid in high-yield savings accounts. We often recommend any of the online banks who pay upwards of 2%. Savers need to be mindful of account minimums in order to avoid potential monthly maintenance fees.
CDs, on the other hand, are best used for short-term goals (1-5 years) or as part of a bond allocation within a brokerage account. More often than not, there is an event or situation that CD money is earmarked for and if it ends up being that those CD funds are not needed whenever the CD matures, then that money can be reinvested in longer-term instruments such as stocks and bonds.
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