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The next step after creating a budget is building up an Emergency Fund.
Overview:
An Emergency Fund is money that is set aside to be used in the event of any unforeseen expenses, such as medical problems, car trouble, or home appliances breaking down. As with budgeting, the amount that you should save is very dependent on your situation. Most people use the 3 to 6 month rule, calculating all of your expenses for a month, multiplying that by 3 to 6 months and that's your number. I feel like this is a good starting point but it's not enough information. I think another variable that should be evaluated is how stable your job is. If you are a manager at a business, you could probably lean towards the 3 month amount. If you are a low level hourly employee, you may want to go for the 6 month amount in case there are layoffs. Another thing I'd evaluate is how high your monthly expenses are. If your monthly expenses are $3,000, you probably don't need 6 months ($18,000) worth of savings since most of the time it will be used for stuff like replacing your water heater or new tires.Inflation:
The big problem with keeping large amounts of money set aside is a thing called Inflation. Inflation is the idea of raising the prices of goods over time. A small amount of inflation is actually good for the economy because it promotes spending money by devaluing the currency which inturn helps businesses bring in money and grow. The percentage of inflation that is widely viewed as being good is 2% per year. The Fed has a way of controlling inflation by manipulating interest rates. As spending increases and inflation goes up, the Fed raises interest rates to promote saving money and not using loans. As spending decreases and inflation goes down, the Fed drops interest rates which incentivizes people to spend money instead of saving it because it will be worth less and take out low interest loans. They can also manipulate inflation by increasing/decreasing the amount of money in circulation. By printing more money, inflation goes up and by taking bills out, inflation goes down.To understand how it devalues the currency, here is an explanation and example:
Lets say inflation stays at the 2% rate year to year. If you start with $100, inflation will devalue the buying power of that money over the next year to the point where you only have the buying power of $98. The next year that would be worth $96.04 and so on. After 20 years, your original $100 can only buy you $50 worth. This explains why candy bars were 50 cents when we were kids but now are $1.50. It's not all bad, as inflation goes up, so does the ability for employers to pay more for workers which raises salaries.
How To Fight Inflation:
In the same way the Fed uses interest rates to counter inflation, we can use interest rates to keep the value of our money. An example of this is you have $100, after a year inflation brings your buying power down to $98 but if you received 2% interest and have $102 in your account, your money didnt lose any value because you balanced out to your original $100 of buying power.Some people think why have an emergency fund that collects very little interest when you could invest that money and make 3 to 5 times that. Because this is money that you need relatively quick access to, I dont like that plan. Investments can go down and you dont want to be forced to sell at a bad time because you need to cover a random event. Instead, I put these funds into a High-Yield Savings Account or a CD (Certificate of Deposit). There is a few pros and cons to these accounts:
| Pros: | Cons: | |
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| High-Yield Savings Account |
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| CD (Certificate of Deposit) |
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Credit Cards:
There is also the mindset that "I'll just put it on my credit card if it breaks", another not so great idea. Although credit cards would help you with the inflation problem because you dont have money sitting around doing nothing, you lose everything you gain by paying interest to the credit card company if you dont pay it off by the end of the pay period. Not only that but usually credit card interest rates are around 25%. In one month, you could wipe out years of interest growth.My Strategy:
I have opened a couple High-Yield Savings Accounts as a base so my money is earning something. As interest rates go up and down, different banks will be more competitive. Below are a few that I would recommend looking into that I personally use:| STCU First5 Savings | If you live in the Pacific Northwest, I'd look to see if you qualify to open one of these accounts. Because it is a credit union, there are geographical restrictions on who can open an account. What makes this account different then most is you receive 5% interest on the first $500 in the account, by far beating any other savings account out there. After the first $500, the interest rate drops to normal low savings account rates on the rest of the money. |
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| Capital One: 360 Performance Savings | Even though this account doesn't have the highest interest rate, they usually compete towards the top. I also use it as a buffer account for my different CD accounts, which I will talk about later. |
| Yotta Savings | This is a new, interesting way to do savings. With this account, you earn a low .2% interest, less than other High-Yield Saving Accounts but higher than other normal savings. What makes this interesting is they have a Lottery system to determine the rest of the interest you earn. You receive a ticket for every $25 in your account ($100 = 4 tickets). You can choose the numbers for these tickets or have it automatically select numbers. Each night at 6PM PST they roll a random number. At the end of the week, Sunday nights, they roll the Yotta Ball. Based on how many numbers you matched, they pay out into your account. The last estimate I heard was over time this would balance out to be about 2% interest with the possibility of more. |
Once the different accounts are open and the money is collecting interest, CD's (Certificate of Deposit) are the next tool I use to lock in higher rates. I keep all of my CD's with Capital One, their rates have always lined up with the other banks and it's nice to have them all in one place. These rates fluctuate based on the Fed changing interest rates. Since the Fed tries to keep inflation around 2%, that is the minimum amount I will open a CD. Since I am locking up my money for an extended period of time I prefer it to be higher around 3%.
Unfortunately, there is always the chance you open an account and the interest rate goes up. It happens to me all the time, I open an account and the next day the rate is higher. I recommend doing something known as averaging in. With averaging in, you open an account only using a fraction of the total amount you have. Then after a little while, you open another account with the same amount. This way if the rates go up, your average rate goes up and you dont miss out. Also, with most CD's there is a penalty for withdrawing early. In Capital Ones case, this can be 3 to 6 months worth of interest. By opening accounts with time in between, you could cover emergencies that come up without losing money if you close the oldest first that have time to build up enough interest to cover the fee.