Most people are able to at least tread water financially. They learn to cut coupons, get pizza a few nights instead of more expensive meals as take-out, and eat lunch at their desks a few days a week instead of going out every day. No matter their income, they come to an equilibrium where they are spending the same amount each month as they are taking in. They then use things like the “extra” paychecks a year – those months where you get 3 paychecks instead of two – or tax refunds to buy luxuries like vacations and toys.
Still, most people get into debt and when that happens, they end up spending a lot of their money on interest instead of putting their whole paycheck toward things like retirement and college savings. The reason they get into debt despite being able to handle the usual monthly expenses is the unusual events that cost a lot of money and seem to come up “suddenly.” Since everything that comes in through salary goes out each month in expenses, they have no savings to take care of things like the new roof or the car repair.
This brings us to the next item in the list provided in 10 Dirt Simple Rules of Money Management, a series I hope my regular readers are enjoying and finding useful. (Note, you can find all of the posts in this series by choosing Dirt Simple from the category list in the right sidebar.) Today we cover the sixth rule:
6. Put money away until you can buy a new roof and a good used car for cash, then invest it in diversified mutual funds until you need the money. Automate as much as possible.
Eventually you will need to replace your roof. Eventually you’ll need a new air conditioner. Eventually that car you’re driving will need to be replaced. When these things happen, you can’t just cut back on expenses and start saving up the money needed at that point because the things are needed now, not five years from now. You need to be putting money away each month as if you are making a car payment, a roof payment, or an air conditioner payment. (Otherwise, you’ll end up taking out a loan to pay for these things and you will be making payments, with interest.) These are things that should be in your cash-flow plan and you should be putting money aside for them each month. Remember that it is more difficult to cut back on spending to save than it is to never have spent all of your paycheck in the first place.
So, right from the first paycheck, open a savings account that you call the “Home and Car Fund” or the “Big Items Fund” or maybe the “Murphy Repellent Fund” and start putting money away. Just figure out the things you’ll need to replace, the approximate cost, and the number of years between replacements. For example, your list may look like this:
|Item||Cost||Replace In(years)||Per Year||Per Month|
|Car (4-year old)||$10,000||5||$2,000||$167|
So now to be ready for when the next disaster strikes, all you need to do is put away $303 per month (maybe round it up to $310) into a savings account. Ideally you should do this as a direct deposit from your paycheck so that you will remember to do it.
Note that everything goes into the same account instead of putting money into a roof fund, a car fund, and so on. This is the better approach since it helps you get ready for any one of the expenses happening in any given month that much faster. If you were only putting $167 away in a car fund to be ready to replace your car in 5 years, but then the car died in 3 years, you wouldn’t have the money needed. Because you’re putting away $303 a month, you’ll have the money you need to replace the car in two years and seven months if you needed to do so. In this way you’re acting like your own insurance company where you put all of the money into one pot and then pay out “claims” as they come up. The only thing to be careful of is taking out money before you really need it because the balance becomes large. Remember that those expenses will come eventually and you’ll need the money when they do.
Of course, most of these things will not happen in any given month, so the balance in the account will build. Eventually you will want to start to invest at least a portion of the money so that you can get a better return and not see money lost to inflation each year. In fact, once the fund reaches a critical mass and is invested, it may sustain itself and you won’t even need to contribute anymore, leaving you free to save your money for other things like a vacation fund, increases in your retirement fund, home upgrades, or whatever else is important to you.
When making the decision to start to invest, keep in mind that this is money that you need to have available when you need it. You therefore cannot lock money up that you’ll need in the next few years away in things like individual stocks that will have unpredictable values from year-to-year. I would therefore do the following:
1. Keep the money in a savings account to start, then shift some of the money to 1 year CDs as the balance built up.
2. Once the balance built to the point that I could do the biggest item on my list (in this case, replace the car or the roof), I would hold that amount in CDs and start to shift new monies into an index mutual fund. I would probably pick a large-cap fund like an S&P500 fund or maybe a total market fund since the fluctuations for these funds would be less than that for small caps or other funds. I might also consider REITS (real estate funds).
3. Once I got to the point that I had 150% of my largest purchase, I might start to shift a bit more into the mutual fund. For example, I might keep enough for 50% of the purchase in bank CDs and the rest in the mutual fund. The reason is that it is very unlikely that I would see more than a 50% drop in a mutual fund, so chances are very good that as long as I had 50% in a bank CD, I’d have enough in the mutual fund to cover the rest of the purchase. Once the value of the fund exceeded about 15 times my annual contribution (about $55,000 for the case above), I might shift the money entirely into the index funds, but raise cash as needed for expenses that I knew were about to occur (see item 4. below).
4. If I saw one of the purchases coming up in the next 2-3 years, I’d start shifting money to bank CDs, and reducing the term of those as needed to have the cash available when needed. For example, if I knew that the roof would need to be replaced in 2-3 years, I’d start selling the mutual fund off at opportunistic times, such as after large run-ups in the market, to raise cash. When I knew I was within a year of needing to replace the roof, I’d shift the money from 1-year CDs into perhaps 6-month or 3-month CDs, eventually just putting the money into a money market fund when I was starting to line up a contractor.
5. I would keep contributing to the fund until the value of the fund was at least 30 times my yearly payment. For example, if my payment were $3,633 as shown above, I would contribute until I had at least $110,000 in the fund. After that, I would be reasonably assured that the fund would be able to sustain itself, with capital gains and dividends from my mutual funds replenishing money as it is spent on expenses. If the balance dropped below that level, I would resume payments into the fund again to bring the balance back up.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.