Erick O. Bell
D.Min, CPA
Haas School of Business, University of California Berkeley
California
People usually save for two reasons: They save for things they currently need and anything that might come up outside their current needs. These things can be items like holiday gifts, summer vacation, a new car, a new house, a college education, etc. Things you do not know are: car breaks down, the refrigerator needs to be replaced, you have to fly to Los Angeles to see about your grandmother’s health, etc. These are all examples of emergencies: Expenses that happen, that we did not plan for.
Following the Millionaire PyramidTM we first need to create a budget. Next, it is time to get your savings account in place. It is important to start with an amount that can cover at least one type of emergency. That typically is between $500 to $1,000. This savings amount is restricted for emergencies only (buying a new pair of shoes does not qualify as an emergency). Once you have established this starter emergency fund, instead of using your credit card to pay for an emergency you can use the savings amount. If you have to withdraw from this account, make it a priority to replenish the balance as soon as possible.
Before you continue to build your starter emergency fund turn your attention to high-interest, revolving debt. As a general rule, you do not want cash earning less than 3% interest if you are paying more than 9% interest for borrowed cash. After you paid off this debt, then move back to funding your emergency fund. Your emergency fund should eventually be 3-6 months of your living expenses. Do not be afraid of that
number: it is your “living expenses”, not your total expenses. Of course, we all enjoy splurging at our favorite restaurant once a month but that is not necessary for living. Also, it is not 3-6 months of your “income”, it is your expenses. You do not need to have 3-6 months ready all at once. You can build your emergency savings fund methodically over time.
The best way to save is to start with your budget (yes, budgets again). Once you have set up your budget and designated a portion of your income for savings, then you will want to automatically have that amount deducted from your checking account. (Even better, you can ask your employer to directly deposit this amount into your emergency savings account).
Your savings should be held in an account that allows for reasonable, but not limited access. The money in your savings account will not earn a lot of interest, sometimes less than 1%. That is okay because the purpose of the account is to cover emergencies, not investing (which we will talk about later). Another place to place some (but not all) of your emergency savings is in a certificate of deposit (CD). CDs earn more interest than a savings account (generally 1% to 2%), but there are more restrictions on when you can access your money. CDs typically have a term limit (ranging from 1 year to 5 years). The longer the term, the higher the interest rate earned.
Once you open a CD account, you cannot access your money until after the term ends. If you need to access your money before the term ends, you may incur penalties and could lose the interest you already earned. For these reasons, you should not place your entire emergency savings into a CD. If you have saved 6 months of living expenses, you may want to place 3 or 4 months in a CD and keep 2 or 3 months in a regular savings account. Another saving strategy with CDs is to use the concept of CD laddering. The strategy requires you to open multiple CD accounts with different terms. For example, you can purchase a 1 year CD, a 2 year CD, and a 3-year CD. When the 1-year CD term ends, then you would purchase another 3-year CD, and when the 2-year CD term ends, then you would purchase another 3-year CD. This will allow you to have one CD term ending every year (meaning you can access your money) while earning more interest.
If you are saving money for a specific purchase (for example, a vacation or an expense electronic device), it is best to keep that money in a regular savings account. Be sure to keep track of the amount you are saving separately from your emergency savings funds. (And yes, you will need to create a separate line item in your budget for that specific purchase…budget, again!)
Savings – Important terms to know
Interest – the amount of money a lender makes when the borrower repays
Interest rate – the percentage of the loan amount the lender charges for loaning money
Minimum deposit – minimum amount of money required to open an account Minimum balance – minimum amount of money a customer must have to keep the account open and/or avoid fees
Savings account – a deposit account held at a bank or financial institution where the borrower earns a small interest percentage and the balance is guaranteed by the government, up to $250,000.
Money market account – a deposit account held at a bank or financial institution where the borrower may earn an interest percentage higher than a savings account and the balance is guaranteed by the government, up to $250,000. There may be limits on the number of transactions and a minimum balance required
Certificate of deposit – a product offered by banks and financial institutions where the borrower may earn an interest percentage higher than savings and money market accounts. The balance is guaranteed by the government, up to $250,000.
There is typically a time limit for the deposit to stay in the account between 1 and 5 years. Early withdrawal penalty No-interest account
Yield – earnings generated and realized over time on your investment Annual Percentage Yield – the percentage of earnings generated and realized over one year after considering the effect of compounding interest. The annual percentage yield is generally more than the interest rate because of the compounding process
Compounding – the process where interest earned from the initial investment is reinvested to earn even more interest. The more compounding, the more money you earn.
Financial goals – short-term, mid-term, and long-term goals that are written down and are specific, measurable, actionable, realistic, and have a timeframe. Your goals are your finish line and help build confidence.
Building savings for emergencies and planning a budget for the future are crucial steps toward achieving financial security and peace of mind. By setting clear priorities, creating an emergency fund, and adhering to a thoughtful budget, you can handle unexpected challenges while steadily progressing toward your long-term goals.
In a consumer-driven world where the urge to spend can be intense, recognizing the significance of saving allows you to make decisions that support your financial health. It’s not about denying yourself pleasure but about striking a balance that ensures your future while enjoying the present. Keep in mind that every small step you take toward saving today lays the foundation for greater financial freedom tomorrow
Erick O. Bell is an accounting and financial wellness professor. He holds a tenured position at Las Positas College, and also teaches at Golden Gate University’s masters program and the Haas School of Business at UC Berkeley.