Saving for a Sunny Day
Saving for short-term goals requires a different approach than long-term investing. This article includes tips for building savings habits.
Planning ahead for large short-term expenditures, such as a vacation or new car, can prevent anxiety and save on finance charges. The first step to meeting your short-term savings goals is to establish a systematic savings routine. A variety of automatic savings plans are available through banks and may be offered by your employer.
The next step is to select an appropriate investment vehicle. Some investments, such as stocks, bonds, and real estate, are probably not suitable for your short-term investment needs because they are either illiquid or too volatile. However, there are a wide variety of short-term investment options available including savings accounts, time deposits (CDs), money market mutual funds, and money market securities.(1) There are also tax-free money market funds and U.S. Treasury securities, which are exempt from most state and local taxes. Some of these vehicles require a minimum investment and each offers different degrees of liquidity, safety, and return. Keep in mind that short-term return is largely restricted by safety and liquidity. You should, therefore, be realistic about how much you can expect to earn.
Most of us know we need to save for our future goals. Buying a home, providing an education for our children, investing for a secure retirement, or just "saving for a rainy day" are the most common savings goals. But what about next year's vacation, remodeling or refurbishing the house, or buying a second car? You can always just say "charge it." That's how Americans have amassed billions of dollars in credit card debt. Or, you could begin saving for these short-term needs today.
The first step in any investment strategy is to develop goals. First, check to see if you have enough reserve funds to cover emergencies or even temporary unemployment. Many financial planners suggest that you have three months' salary available in savings for the unexpected. Then, take a look at your spending needs over the next 12 to 24 months. How much did you spend on your last vacation? How's the car running? By planning ahead for large expenditures, you can prevent anxiety and save on finance charges. Once you've determined how much you need and when you'll need it, you're ready to begin matching your investment objectives to the investment options available to you.
It sounds easy, but if you're like most people, you may lack the discipline to save. Banks offer a variety of special-purpose savings plans designed to help. Vacation and Christmas Clubs use coupon books that provide a schedule for reluctant savers. The idea is to make savings a habit. Whether or not you use coupons or clubs, you can treat your savings deposits like your rent or mortgage payment, and write a check each month (or even each week) for deposit into savings.
Many companies offer automatic payroll deductions for savers. Money that you don't see might not be missed, and it can add up quickly. If your company doesn't offer payroll deductions, you can set up your own automatic transfers from your checking account to your savings account. Money market mutual funds also offer automatic investment plans.
Selecting an Investment Vehicle
Whether your goals are long term or short term, you should look at three investment factors before choosing a savings or investment vehicle: liquidity, safety, and return.
Liquidity -- When can you get your money? If you're saving for next year's vacation, real estate is probably not a good investment. But even certificates of deposit (CDs) may be too restrictive. Be sure you understand what it might cost to turn your investment into cash. Are there penalties for early withdrawal? When you are using a time deposit, make sure your investment's maturity matches your needs.
Safety -- As a general rule, return is proportional to risk. (That's why the old horse with weak legs pays 40 to 1.) Just as liquidity concerns would rule out short-term investments in real estate, safety factors would rule out short-term investments in stocks or bonds. It's not that these investments are inherently unsafe, but that the volatility (or fluctuation in the value) of these investments often makes them unsuitable for short-term investing.
Another concern is credit quality. FDIC-insured products often offer lower returns than mutual funds. The U.S. Treasury is a better credit risk than a corporation. You need to determine what level of safety you are comfortable with, realizing that increased safety usually means lower returns.
Return -- Short-term investors are restricted by safety and liquidity. You should, therefore, be realistic about how much you can expect to earn. Still, there are many investment choices available. Keep in mind that your final return will be reduced by any fees or taxes you incur.
While some investments require a minimum amount, others do not. Generally speaking, the more you have, the more you can earn. Even if you don't have the $500 for a CD, you can still save $50 a week until you do.
Savings Accounts -- Given their convenience, availability, and relative safety, banks are often the first choice for savings. Accounts at FDIC-insured banks are protected up to $250,000 per depositor. Shop around for rates and fees, keeping in mind that banks will usually waive monthly fees if you maintain a minimum balance. Most banks will link your savings and checking accounts. Try keeping most of your money earning interest by writing checks once a week and transferring the money from your savings account as needed.
Money Market Accounts -- These accounts generally pay a higher rate than passbook savings accounts, with a rate that fluctuates with market conditions. You may also get the advantage of limited check writing.
Time Deposits -- CDs are available with terms ranging from 7 days to 30 years. CDs are FDIC insured and offer a fixed rate or return if held to maturity. A fixed rate CD may or may not be an advantage. The time to lock-in is when rates are at their peak. Since it is difficult to know when rates have peaked, you can stagger maturities to limit your interest rate risk (the likelihood that rates will rise or fall). By purchasing CDs with a variety of maturities, you can reinvest principal from maturing CDs if rates go up, while longer-term CDs will continue earning higher returns should rates fall.
Banks may also offer CD products with variable or adjustable rates. Others may be tied to stock indexes or the price of gold. You need to assess the risk, liquidity, and cost of these options to find a product that you understand and are comfortable with.
Relationship Accounts -- Many banks reward their best customers with relationship accounts. By consolidating your deposits and loans with one bank, you can often minimize fees, earn higher rates, or get free services. Check with your bank to see if this option would benefit you.
Money Market Investments
Government agency certificates
Certificates of deposit
Money Market Mutual Funds(1)
Money market mutual funds pool investors' dollars to buy short-term securities such as commercial paper and Treasury securities. Interest paid on these investments is passed on to shareholders in the form of dividends. Dividends as a percentage of the price of the fund are referred to as the fund's yield, which is usually expressed in annual terms. While these funds strive to maintain a fixed price (net asset value or NAV) of $1, the yield fluctuates daily. Typically, money market funds lag behind the market such that yields increase and decrease more slowly than market rates in general.
Money market funds offer many conveniences, including check writing. Although they are considered safe, they are not covered by FDIC insurance. If safety is a concern, funds are available that invest only in U.S. Treasury obligations. However, while Treasury securities are guaranteed by the government, the funds that invest in them are not. If you are in a high tax bracket, a tax-exempt money market fund might be a good idea. Check to determine if the fund is tax free for federal, state, and/or local taxes. Then calculate the taxable-equivalent yield.
U.S. Treasury and Other Money Market Securities
You can buy the same securities as the money market mutual funds. U.S. Treasury bills (T-bills) are generally issued in 13- and 26-week maturities with a $1,000 minimum investment. You can also purchase T-bills with shorter maturity rates directly through banks and brokers. T-bills are sold at a discount, which means that the interest is paid to you when the bill matures. A 26-week $10,000 T-bill yielding 5% will be discounted by $252.80: You'll pay $9,747.20 ($10,000-252.80) to buy the bill and receive $10,000 at maturity. An added bonus is that interest earnings on T-bills are exempt from most state and local taxes. However, earnings may be subject to the alternative minimum tax (AMT).
In addition to Treasury securities, a wide variety of short-term commercial securities are available. The yields will be higher than T-bills due to the increased risk. Unlike mutual funds or bank money market accounts, these investments pay a fixed rate of return.
1 An investment in a money market fund is not guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the fund seeks to preserve your investment at $1.00 per share, it is possible to lose money by investing in the fund.
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