Save 10%, 20%, 50% of your income – be frugal, spend less, don’t have that latte….
These are all narratives we find in financial advice articles, podcasts, videos, lectures …
But no one tells you what is the purpose of this savings. Mindless savings do not stay, and end up paying that credit card once the expenses (and debt) start peaking during a season or month.
Dave Ramsey says repeatedly – once you have a fully funded emergency fund and investing 15% of your income, throw all extra money at the mortgage. Is it so simple? What about other goals? Do we just live for Emergency, Retirement and Home Equity?
The truth is far from different. There are several objectives and goals that a person has to take care of between Emergencies and Investing.
In this post, I will discuss at least 4 types of savings most people will need to care about. There could be more according to your situation, but these are the broad 4 I have seen working with clients.
Emergency Fund
I will start with this since in the current environment when layoffs are becoming more common and another recession looms in the horizon, there cannot be a better time to save up that Emergency Fund in 2023.
How much should you save up for an Emergency Fund? Again, financial gurus throw a thumb rule like 3-6 months of expenses, some say 1 year if you are an entrepreneur and may be 2 years if you are close to or planning to retire early.
There is no right answer here unfortunately, and thumb rules are not so effective. So most people will convenient choose to do the minimal (savings is hard, isn’t it?) – 3 months of expenses.
There are several problems with a number like 3, 6, 12, or 18. Some questions:
- How accurately do you know your expenses?
- How do you calculate monthly expenses? Is it maximum, minimum or average for all months?
- Will it be same when emergency or job loss strikes?
- Do you consider only fixed expenses or variable (discretionary) ones? Are you going to live on beans and rice?
- Do you include other goals in your emergency fund? For example, do you want to stop all travel or eating out, meeting friends just because you lost your job?
See there is no right answer and a 3-6-9-12 kind of an estimation is not sufficient.
So be conservative and ideally save up an emergency fund that will help you continue living your normal life. That’s freedom and then define how many months of freedom you want.
Make your life predictable by saving up that Emergency Savings bucket.
In the following, we are going to discuss how to make the estimation of the Emergency Fund itself more predictable.
Maintenance or Deductible fund
This is the fund that is less severe than an Emergency. This could be for things like:
- a medical expense which is out of the ordinary. Your insurance may require you to pay a deductible.
- something breaks in your home (an appliance) and your home insurance will not cover it.
- The roof gets damaged in a storm and you need cash to repair it while applying for insurance.
- Smaller repairs and regular maintenance of your car.
So these are not the once-in-a-lifetime Emergencies but smaller inconveniences if you do not have the cash saved up. Typically most people will charge these on their credit card and include in the monthly expenses. But that makes your expenses more variable throughout the year and makes it difficult to calculate the Emergency Fund.
So if you have a separate fund for maintenance and deductibles, your monthly expenses are more predictable and so is your Emergency Fund calculation.
Make it predictable by opening that Maintenance Savings bucket.
Obligation Fund
Who likes to pay Taxes and Insurance premiums? I don’t. But these are necessary evils for your sanity – you want to keep the IRS away from your front door and emergencies away from your back door.
Good thing is that these are a lot predictable. You know the premiums (to a large extent), property taxes and any estimated/advance/quarterly/annual tax that you have to pay. So why not plan for it?
Rather than the bill popping up and upsetting the monthly budget, simply save for the amount in a savings bucket every month.
Note that such expenses need to be included in your Emergency Fund calculation, even though it is not a regular monthly expense. The IRS, Insurance company or the County will not listen if you lost your job (sure they may give you some temporary respite). Eventually the emergency will be over and you will be required to pay up all your obligations.
It is very easy to miss this in the Emergency Fund calculation, and scramble at the year end to pay up.
Make it predictable by opening that Obligation Savings bucket.
Fun Fund
Financial gurus may cringe at that. How can you have a Fun Fund when the goal is to be frugal?
And then, during a job loss or emergency – aren’t you supposed to live on beans and rice and no coffee?
No, that is the not the goal for me. I would rather have my Fun Fund, Travel Fund, Hobby Fund etc.
This is the real Pay Yourself First. If you have this, your life will not be completely topsy turvy when there is an emergency.
Now there are several ways to save up for this. Either you can set it aside and spend it every month on shopping, eating out, travel and whatever makes you feel good. Or you can accumulate and wait for the right time and value to appear in the market.
Just do not overdo it, it does not mean mindless spending or buying expensive cars. It is the amount that truly gives you happiness and over a long term hopefully. Instant gratification for things that become useless in a few days is childish. Hope you get the point.
I spend a decent amount on books and travel because those are what I love. They are also long term since knowledge and experience can neither be taken away from me nor they diminish over time.
Planning for this helps in two ways. It prevents the impulsive shopping habit, thus making your monthly budget more predictable and so your emergency fund. Secondly, when you consciously budget for it, you are more mindful towards what to spend it on, the real priorities and not wasteful expenditures.
Make it predictable by opening that Fun Savings bucket.
Conclusion
Thumb rules, 5 steps etc. are not very useful for most people’s situation. Personal Finance is so personal that assigning a common number or goal for everyone is difficult.
In this post, we have discussed how to make your personal financial situation more predictable in these times of extreme volatility and uncertainty of the job, stock, bond, real estate markets.
If you or anyone you know need help with organizing their finances, please schedule a call with me:
