There is one cushion or comfort zone that you don’t want to get out of.
Everyone knows the importance of saving that cash. No I am not saying investing but just plain boring savings in a savings account.
Sometimes this is done as a byproduct of spending less in a month, which means there is some surplus left after you pay yourself and pay your bills, including the credit card.
However this surplus does not stay for long, as invariably next month it gives you a good feeling and you say “what the heck” – I spent less last month, so let me overspend a little this month. Hence it just disappears in next month’s bills.
Like investing, it is important to plan for savings too. The cash required to be saved is for various reasons, like a rainy day, home maintenance, car maintenance or even bills to be paid at the end of the year such as insurance and taxes.
According to Dave Ramsey, you should be in a position to pay cash for everything, except for buying a house or investment property.
How to build the required cash cushions
The blog post on budgeting talks about how you can partition your paycheck to investing, expenses and savings.
The savings part can be divided into four important goals.
- Emergency Fund
- Maintenance Fund
- Obligation Fund
- Leisure Fund
The Emergency Fund
This is for that unforeseen day when things will go wrong despite your best efforts to prevent them. It can be medical emergency, job loss, the damaged roof or the HVAC stopped working. These all can be high valued expenses, and if there is no reserve it will cause much financial distress and debt.
The general notion is to maintain 3-6 months of expenses in a savings account.
Since this money is not intended to be spent in short term (and as long as there is no real emergency), there are two important aspects.
- The savings need to be in a separate bank account than your normal day to day checking account. In fact, it is best kept in an online money market savings account (FDIC guaranteed) to earn a little more interest than a plain vanilla savings account.
- It should be difficult to access that account for day to day expenses and should require a special trigger (a real emergency) from you to transfer funds back to your regular checking account.
Just like pay yourself first, keep transferring a quarter of your savings goal to this account every month, till the 3-6 months reserve is built up.
The Maintenance Fund
This is the catch all maintenance reserve. It is important if you own a home or car, or even expensive gadgets that will require maintenance.
This account can be maintained in a separate savings account but in the same institution where your checking account is, so that small maintenance tasks can be serviced easily.
You should be able to move funds in a matter a seconds from your maintenance savings account to the checking account, to pay for repairs etc. or pay the requisite credit card balance arising due to the maintenance expense.
The Obligation Fund
The Obligation Fund is actually part of your expenses but not monthly paid out. There are those bills that hit us at the end of the quarter or year, for example HOA bill, Property and Income Tax, and Insurance premiums.
It is a good idea to pay as much of your bills every month, but in some cases you may get a good discount paying it for the entire year in advance. I mostly pay the car insurance and home insurance (bundled together with one provider) annually to get a special discount.
This requires me to save up for the next year’s premium in advance. The best way to build these savings, is to divide the expected amount by 12, and keep stashing away as if you are paying a fixed bill every month.
This account can be maintained in yet another separate savings account than your checking account. Or better is to save this in a money market savings account since you know when exactly you need it, and it can accumulate some interest in that time.
The Leisure Fund
The Leisure Fund is the one which helps you save for vacation, indulgence, or plain simple fun spending.
It is same as an Obligation Fund – think about it as an obligation to yourself.
For me, visiting India every summer is a priority and hence a part of this fund is allocated to save up for the expensive airfare.
This account can be maintained in a money market savings account since you know when exactly you need it, and it can accumulate some interest in that time.
In this post, I have presented a simple plan how to be prepared for unforeseen events and short term obligations.
Automating the bank transfers from your main checking account will build these savings in no time. Also as you spend according to the purpose, the automatic transfers help keep replenishing the savings month after month.
Here are some recommendations for bank accounts for the above 4 savings goals. I personally use the Capital One 360 Savings and Money Market accounts.