High-Yield Savings Accounts

ben_franklin_2There are (at least) 3 different kinds of savings accounts at credit unions and banks.

  • Regular or Basic Savings.  Used to be called “passbook” savings accounts.  Low minimum balance requirement.  Allow an unlimited number of withdraws, which may be made at any time.  Pay the lowest amount of interest.
  • High-Yield Savings.  Limited number of withdraws, but withdraws may be made at any time.  Pay higher interest (but not as much as certificates of deposit).
  • Certificates of Deposit.  “CDs” or “time deposits”.  High minimum balance requirement.  No withdraws until after a specified time (months or years).  Pay the highest interest.

If you’re keeping all of your emergency savings and other savings accounts in a regular savings account, the value of your savings is decreasing as inflation takes its toll.

You savings could be earning a higher interest rate if you put them into certificates of deposit, but then the money won’t be immediately available to you if you need it to take care of an emergency.

A high-yield savings account, which combines the best features or basic savings accounts and CDs, might be just right.  You can make withdraws whenever you want (but you are limited to a certain number of withdraws per month), but at least you’re getting some interest that will offset the effects of inflation.

Search the internet, and you’ll will many banks offering high-yield savings accounts.

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Save or Spend: Give Money To Your Future Self … or … Take Money From Your Future Self

Oftentimes, when it seems easier to do the wrong thing (like, it’s easier to spend some money now to get some immediate gratification) instead of the right thing (like, avoid spending money unnecessarily), it can get easier to do the right thing if I find a different way of thinking about it.

credit_devilSure, I might like to have something from one of the restaurants next door to my office.  There’s a lot of ways to spend money: sandwiches, ice cream, doughnuts, pastries, iced coffee.  I could easily spend $5 or $10 there every day.  And why shouldn’t I?  I work hard.  I deserve a treat.

Then I think of my future self.  I see myself 20 or 30 years from today.  What about him?  Don’t I want him to be as comfortable as possible?  Maybe he would like to have money for a sandwich or some ice cream.

It’s as simple as that.  The more I spend today, the less I can give to my future self.  So, when I’m at work, if I can make do with the food I’ve brought from home, I can give a bit more to my future self.

  • Spending now is taking money away from my future self.
  • Saving now is giving money to my future self.

(And spending now by borrowing now, by means of charging today’s spending on a credit card and then having to pay interest, now that’s really taking money away from my future self!)

A $1,000 Emergency Fund Savings Account: One Thing Dave Ramsey is Right About

I don’t mean to imply that Dave Ramsey is wrong about a lot things.  Generally, his advice is very good, although it does tend to be a bit simplistic and one-size-fits-all.  And there is a raging debate about paying off debt using the “debt snowball” method he recommends.  But if there’s one thing that he gets 100% correct, it’s his “Baby Step Number One”, setting up an Emergency Fund savings account getting $1,000 in it.

Emergencies are certain to happen.  Anything mechanical — such as a car, washer, dryer, furnace, air conditioner, water heater, oven, dishwasher, etc. — can break down.  Roofs can leak.  Pipes can leak.  Computers crash and die.  Pets need veterinarians.  People need doctors.  Or lawyers.  Or bail.  It’s not a question of “if?”, it’s a question of “when?”.

$1,000 might not be enough to take care of every emergency.  Some emergencies will cost a lot more.  But $1,000 will take care of a lot of the emergencies that will come your way.  Even if it’s not enough, at least $1,000 is a start.

If you live paycheck-to-paycheck, if you earn just enough each month to pay your predictable bills and you have nothing saved in an Emergency Fund savings account, then you are unprepared for anything unpredictable … and “unpredictable” is part of the definition of “emergency”: an unforeseen combination of circumstances or the resulting state that calls for immediate action.

Maybe you think you can just use credit cards.  Big problem: If you have no savings, and all of your income in a normal month goes to pay that month’s predictable non-emergency expenses, then you won’t be able to pay off the credit-card bill when it comes due the next month.  That means the credit card will start charging interest — effectively increasing the cost of your emergency.  As if the emergency itself isn’t costly enough, you want to add to it?  If you can’t pay the minimum amount due on that credit card bill, then you’ll have compound interest working against you.  This is bad.  (Hint: compound interest should be working for you, not against you.)  Also a problem: The banks can say “no” at any time, cancelling your card or reducing your credit limit as they see fit.  When it rains, it pours, right?  This also holds true for using a home-equity line of credit.  If you’re living paycheck-to-paycheck, how are you going to pay back a home-equity loan?  And again, you’re at the mercy of the bank: The bank can reduce or eliminate your home-equity limit at any time, and are likely to do that if you’re unemployed or if the economy shows signs of recession.

The smart thing is to be prepared.  Now.  Open a savings account at your credit union or bank and start putting something into it — $100, or $75, or just $50, or whatever you can — every time you get paid.  Pay yourself first: Put that money aside before you spend any of your take-home pay on anything else.  If you get paid twice each month, $50 from every paycheck will get you to your initial goal of $1,000 in less than a year.  If you can set this up to happen automatically, so much the better.  Keep putting that money into the account until you have at least $1,000.  As you savings grow, you will enjoy the sense of well-being and security that comes from having a little something set aside.  You will sleep better at night.  One less thing to worry about.  You can take care of a $1,000 emergency!  As it says in The Richest Man in Babylon, “Soon ye will realize what a rich feeling it is to own a treasure upon which ye alone have claim.

keep_calmOnce you have your $1,000 Emergency Fund, make sure you don’t use it for anything except a genuine emergency: an unforeseen combination of circumstances or the resulting state that calls for immediate action.  Don’t give in to any temptation to spend it on anything else.  Once you have met your goal of saving $1,000, it’s time to set yourself a goal of having $2,000 at the ready.

Sooner or later, that unforeseen combination of circumstances or the resulting state that calls for immediate action, i.e., the immediate spending of money, will happen.  When it does, don’t borrow money by using a credit card.  Instead, you “borrow” from your own emergency savings.  Spend carefully, but take care of whatever needs taken care of.  Then, as soon as you are able, you “pay it back” by making your usual deposits to your Emergency Fund every time you get paid, building it back up to where it was before the  emergency, and then beyond that.

If you don’t have an Emergency Fund, why not?

If you think you can’t save $1,000, then think again!

You can work more.  Work more hours.  Get a second job.  Mow grass.  Wait tables.  Flip burgers.  Whatever it takes, get that money into your Emergency Fund.

You can spend less.  Get a cheaper cellphone plan.  Cancel your cable.  Don’t eat anything you didn’t buy at a grocery store and cook at home.  Whatever it takes, get that money into your Emergency Fund.

You can sell some stuff.  Downgrade to a cheaper car.  Turn some unneeded clothes into cash.  Clean out the whole house and have a yard sale.  Whatever it takes, get that money into your Emergency Fund.

The four paragraphs above are very important.  Saving money and putting it into an Emergency Fund isn’t just a good thing because it prepares you to better handle an emergency.  It’s also an exercise in living below your means, spending less than you earn.  You know, “Do not save what is left after spending; spend what is left after saving.”  Imagine your income is water flowing into a tank and your spending is water flowing out.  If the water flows out as fast as it flows in, the tank will never get full.  No matter how high the income, people who spend all they earn — people who are unable to live below their means — will never have wealth.

The same thing that builds your emergency fund is what will build your net worth.  If your net worth is negative (your debts are greater than your assets), then spending less than you earn will allow you to pay off those debts.  If your net worth is zero or not much more, then spending less than you earn will allow you to save and invest.  Remember, the Emergency Fund is the first step.

Latte Factor vs Saving on the Big Things

If you read personal finance magazines, books, and websites (especially topics like financial independence and retiring early (sometimes called “FIRE”), etc.), you have probably seen articles about how much money you can save by consistently saving on little things, like your daily coffee.  One personal finance guru has an online calculator.*

Then there are others who say don’t sweat the small stuff and focus instead on the big things; instead of wasting your time trying to save money by modifying your coffee habit, you should save money on your car and house.

latte_factor

The “Latte Factor” is one presentation of the little-things-add-up-to-big-things philosophy.  “Watch the pennies and the dollars will take care of themselves” is another way to say it.  This way of thinking has plenty of proponents, myself included.

As mentioned above, you’ve probably also seen articles about how much you can save on the big things.  At least one expert (which is to say, someone who has written a book and sells it on his website) says, “forget all that little stuff, I’ll show you how to do big things and once you do them you won’t need to worry about the little things” [my paraphrase].  Save on the big things, and you won’t have to worry about the little things, the thinking goes.

So, we have a debate: Which is better?  Saving money by consistently reducing or eliminating spending on a small purchases (e.g., fancy coffee like latte that you might purchase 200 to 250 times per year) … or … saving money on a big purchase (e.g., a car or your house that you might have only several times in your life) and the semi-big expenditures like cable television, telephones, and credit-card interest?

It seems to me, it’s not an either-or proposition.  There’s no reason you can’t save on both the small things and the big things.  In my opinion, saving on the small things is good training for saving on the semi-big and big things.  Kind of like in professional sports, start in the minor leagues and then move up to the majors.  It reminds me a bit of the sentence in “The Richest Man in Babylon” where Arkad says, “If I set for myself a task, be it ever so trifling, I shall see it through. How else shall I have confidence in myself to do important things?”

Set yourself the task using your habits of frugality, efficiency, and economy to save money on the small things and you’ll find you can also save money on the big things.


* I’ve experimented with the calculator at http://davidbach.com/latte-factor/ and have found that the weekly and monthly calculations do not match (aren’t even close) to results I get with other online compound earnings calculators.  However, the daily calculations are consistent with other results.

Remember the Ant and the Grasshopper

A few years ago, I saw “The Grasshopper and the Ants” (Disney’s short film of 1934 based on Aesop’s fable, “The Ant and the Grasshopper”, available in various book, audio, and video formats) and I was reminded how well Aesop’s fable, even in Disney’s presentation, teaches a valuable lesson.

grasshopper_and_ants

Aesop observed nature, which to him seemed to show that ants are industrious insects who work all summer and thus have plenty of food set aside for winter.  Grasshoppers, on the other hand, spend their summers frolicking and making music, and come winter are seen withered and dead.

When I first heard this fable as a child, I am sure I grasped the idea that we need to work during the summer so we have food in the winter.  My mother grew up on a farm and I visited her parents’ farm enough to get some idea of the cyclical seasons of farm life.

But when I saw Disney’s  “The Grasshopper and the Ants” recently, from a vantage point well past life’s mid-point, it suddenly seemed clear that the message, the real moral of the story, doesn’t pertain only to the seasons of a single year, but rather to the seasons of an entire life.  During the spring, summer, and fall of life, you work, gather, harvest, and save (you know, pay yourself first) … and during the winter of your life, what you have set aside provides security and enjoyment.  Or, be like the grasshopper: play, spend and set nothing aside when you should and suffer the consequences later.

One more thought: Some commentators say that the Disney version changes the meaning of Aesop’s original fable because instead of leaving the grasshopper to starve, the ants invite him in to share their food and hospitality.  I think this is partially moderated by two things.  One, sharing is part of the enjoyment that can be derived from having.  Two,  in return for his supper and a place by the fire, the grasshopper is obliged to make music for the ants, literally singing for his supper; this shows he might have finally learned the fable’s moral.

Here’s an English translation of Aesop’s original:

aesop_ant_grasshopperaesop_ant_grasshopper_2

Accounting For Different Kinds of Accounts

savings_bank

Different kinds of accounts where you can keep your money … and how to use them.  This is the way I do it.

Checking account (for day-to-day expenses).  Even if it’s only used to fund ATM withdraws, debit-card purchases, and online bill paying, everyone should have a “checking account” — despite the fact that many people don’t even have blank checks these days, Indeed, the last time I purchased blank checks I probably got enough to last the rest of my life.  A checking account is for your usual day-to-day bills.  It should have enough money to cover transfers to your savings account (pay yourself first) as well as your regular monthly expenses, such as the rent or mortgage payment, and bills for utilities, groceries, transportation, and other things that you pay for daily, weekly, or monthly.  Whatever comes out of your checking account should be replenished by income coming in.  (Did you see the post about how the money in your checking account is like a tank of water?)

In addition to your checking account for expenses that come due every month or more frequently, you should also have separate accounts for expenses that come less often.

The first three, like the checking account, should be at a credit union or bank.

  • Emergency savings (unexpected expenses).  Everyone should have money set aside for emergencies, those unfortunate unforeseeable expenses: accidents, medical problems, periods of unemployment.
  • Short-term savings (once-or-twice-per-year expenses).  Money set aside for foreseeable and predictable expenses that come once or twice per year, such as property tax and homeowner’s insurance payments, and expenses for birthdays, holidays, and vacations.  At my credit union I have a “Holiday Club” account that automatically takes $83 (or any amount I choose) from my checking account each month and deposits it into the Holiday Club account.  Then at the at the end of November, the accumulated sum is automatically moved back into my checking account.  It’s a pleasant surprise to get $1,000 just in time for Christmas.
  • Medium-term savings (once every few years or just a few times per lifetime).  Money for foreseeable, but perhaps not predictable, expenses that come less often than yearly, such as purchases and/or repairs of automobiles, refrigerators, heating and air conditioning systems, washers and dryers, and major household expenses such as a new roof.  Other medium-term savings goals might include medical or dental procedures; weddings and funerals; house purchases, remodeling or additions; college educations, starting a business, or moving to a new house.  It’s also good to have ready cash for unexpected opportunities such as great deals at a going-out-of-business sale or a used car at an especially good price.

The last one should be with a mutual fund company so the money can be invested in stocks.

  • Long-term savings (once in a life).  For foreseeable expenses that come just once in your life, such as buying your dream house and retirement.  Basically, your 401-K, IRA, and similar.

How much should you put into these savings accounts each month?

There’s no definitive answer.

Let’s start* with at least 10% to 15% of your total household income going into your retirement savings.  After that, maybe an additional 1% to 5% of your income distributed among the short-term, medium-term and emergency savings accounts?  There are many factors to consider:  How large is your family?  Are your kids going to need braces?  Can they get scholarships for college?  How handy are you when it comes to doing home repairs?  Do you need to buy new cars or can you be content with “pre-owned” cars?  How much will your home addition or dream house cost?

Your goals should be something in the order of at least $1,000 dollars each in emergency savings and short-term savings and perhaps several thousand dollars (or perhaps much more) in your medium-term savings account.

You might want to think of it in terms of your income:

    • Emergency savings.  Equal to at least 3% of your annual income or $1,000 to $2,000 (whichever is higher).
    • Short-term savings.  At least 3% of your annual income or $1,000 to $2,000 (whichever is higher).
    • Medium-term savings.  At least 10% to 50% of your annual income.
    • Long-term savings.  25 times your annual income (when you reach retirement age).  In other words, millions.

There are many experts who say your emergency saving account should have 3 to 6 months of living expenses (all the normal food, shelter, and transportation expenses). This might be around 30% to 40% of your annual income.  One of the reasons for this amount is to maintain your household during periods of unemployment.  If you think of unemployment of an “emergency” then your emergency account should be correspondingly larger.  Alternatively, you could view your medium-term savings as your unemployment reserve.  How likely you are to experience a period of unemployment is also a consideration.

* This assumes you have no debt other than a mortgage.

“Compound Interest” vs “Compound Earnings”

dividend_stocksRepeatedly I see the term “compound interest” used to describe the growth of stock market investments.  I think this is incorrect.

Strictly speaking, you only get interest from bank deposits and bonds.  If you invest any interest you earn by depositing it in the bank or buying more bonds, then you earn interest on the interest — and that’s compounding.

If you invest in stocks, you (might) earn dividends.  If those dividends are reinvested by using them to buy more stock, then you will start earning dividends on the dividends  — and that’s compounding.  But because there is no “interest” earned on stocks, I don’t think it’s right to call it “compound interest”.

Henceforth, I suggest we use “compound interest” only for investments in bank deposits and bonds … and we use “compound dividends” for investments in stocks.  We can also use “compound earnings” in a general way to refer to any investments that grow as their earnings are reinvested in the same investment.


A little further explanation:

The interest you get from bank deposits and bonds arise from a contract: you deposit your money in the bank or you buy a bond (in both cases you are, in effect, lending money and the borrower is agreeing to pay you interest), and the bank or bond issuer is legally obligated to pay you the stated interest and return your money (the principal) to you.

The dividend you get from owning stock is a portion of the profits to which you are entitled because by owning stock you become a partial owner of the company in which you purchased stock.  However, dividends are not guaranteed as there might not be any profits or what profits there are might be used for something other than dividends, such as expansion or development of new products.