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Strategies for savings

How to amass cash for emergencies and future purchases

Consumer Reports Money Adviser: October 2010

One lesson of the recent recession is the importance of stashing away cash in case you lose your job, your investments falter, or you're hit with some other calamity. That's in addition to what you're setting aside for retirement or college for your kids.

It's a lesson that many Americans have taken to heart. Savings as a percentage of disposable personal income climbed to 5.9 percent in 2009 from 2.1 percent in 2007, according to the Federal Bureau of Economic Analysis. In a spring 2010 survey by the Consumer Reports National Research Center, 43 percent said they were putting more money into savings.

Set a goal

How much should you save, and where should you keep the money? As with most financial matters, it pays to have a plan.

A reasonable goal is to save six months of living expenses, perhaps more while the economy remains sour, says Diahann Lassus, a former chairwoman of the National Association of Personal Financial Advisors and president of Lassus, Wherley & Associates, a wealth management firm in New Providence, N.J. "In an ideal world 12 months is what you want."

But the amount that makes sense for you depends on a number of factors, including your job security, your health and the quality of your health-care coverage, and how much debt you have. Other considerations include the number of wage earners in your household; whether you have dependent children; your access to emergency sources of credit, including home-equity lines and even family members; and the likelihood you'll need to make major purchases or repairs.

An emergency fund will help you keep your household running if you lose your job or face any other costly crisis without having to borrow, especially in a tight credit environment, or cash out your investments at what could be an inopportune time. To avoid the temptation of spending that money, create a separate capital fund for big-ticket expenses you expect within the next five years, such as a new car, a major vacation, or a down payment on a house. That will also reduce the need to use credit cards for those items.

Getting there

Most people would find it difficult to save six months of living expenses quickly. But it's not impossible. Take a hard look at where your money is going—your fixed expenses and your discretionary spending— to see where you might free up some cash to put toward savings each month.

"You have to try to play a balancing game," says Jeremy Vohwinkle, a financial planner who has written about emergency savings on About.com. "Try to get some emergency savings right away; tackle the debt as soon as you can; look at your upcoming intermediate expenses and see how important they are."

Your basic living expenses, including mortgage or rent, utilities, insurance, food, and clothing, should equal no more than about 60 percent of your income. The remaining 40 percent should be for discretionary spending, savings, retirement, and investing. If your living expenses exceed that, consider changing your lifestyle or finding sources of additional income.

If you're like many people, you're already making regular contributions into a retirement fund and perhaps building funds for your children's education. If your emergency fund is inadequate, you might need to adjust those contributions, along with discretionary spending, if you have nothing left at the end of the month. But try not to reduce your retirement contributions below the threshold for getting your employer's full 401(k) match.

As tempting as it might seem, don't tap your retirement funds or college savings if you run into an emergency, because it can be costly. You'll pay income tax on IRA withdrawals, and if you take them before age 59½ you might be subject to a 10 percent tax penalty. The same applies if you borrow from your 401(k) or 403(b) and don't pay it back within five years. Make a nonqualifying withdrawal from a 529 college savings plan and you'll pay income tax and a 10 percent penalty on any earnings.

If you have credit-card debt, you'll need to factor that in, too. Once you determine how much you can set aside, have the money taken out of your paycheck automatically and direct it to your emergency and capital funds. Review your budget periodically and adjust your spending and savings as needed.

Build your emergency fund before putting anything away for big-ticket items. If a purchase becomes a necessity—say your car comes to the end of the road earlier than you expected—you can tap your emergency fund for that. But put that dream vacation to Tahiti on hold until your emergency account is fully funded.

Where to keep it

Emergency money should be deposited where you can get to it quickly. That rules out bank certificates of deposit, which generally charge a penalty for withdrawing funds before maturity. Most mutual funds allow quick access, but you run the risk of having to cash out shares when the market is down, possibly way down.

The safest place for your money is in a bank savings account. You can find the highest-paying accounts by checking the national savings and money-market rates at Bankrate.com. (Sort the results by the APR column.) Also check the websites of local banks and credit unions, which might have higher rates than national banks.

You have more flexibility with money you're accumulating for major purchases. If you're saving for a new car several years from now, you might put the money in CDs and short-term Treasury bills and bond funds. But don't tie up your funds for more than about a year. If rates begin to rise, you could end up having your money stuck in an account paying below-market rates. And don't choose a maturity that's after the date you expect to need your cash.

Once your savings goals are met, reallocate money to investments like stocks, bonds, and mutual funds. Those are generally appropriate only for cash you won't need for at least five years.

What comes first: Pay debt or build emergency savings?

Suze Orman, the TV financial personality, says that an emergency fund is so important these days that people shouldn't pay more than the minimum on their credit cards until they stash away at least eight months of living expenses.

Orman, who in normal times recommends paying off debt first, modified her advice after the financial crisis. She says that's because some people used their emergency money to pay off debt only to find that lenders, having turned cautious, closed their accounts, leaving them unable to meet basic living expenses because of a job loss or other emergency.

"Please tell me how they are going to keep the family going if they have no savings and no access to credit," she said in an e-mail response to our questions. "That's why I am so focused on doing everything possible to build emergency savings."

Still, it can take years to amass the equivalent of eight months of expenses, especially for people with little or no savings to begin with, which is often the case for those with a lot of credit-card debt. Paying the minimum on your credit card all that time can translate into huge finance charges.

Our Money Lab analyzed how this might play out. Assume you have $4,000 in monthly expenses, a $5,000 balance on a credit card charging 18 percent interest, and $500 available each month to apply to your debt and/or savings. If you made the minimum card payment each month and put the rest toward your emergency fund, it would take you more than six years to accumulate $32,000, the equivalent of eight months of expenses. And you'd still owe about $700 on your credit-card balance, after having paid more than $2,400 in interest. That assumes you don't charge anything else on the card.

Over the shorter term, after 12 months your emergency fund would have only about $3,900, not enough to cover even a month of living expenses. So unless your expenses are very low or the amount you can contribute to your cash cushion is very high, you won't build up savings quickly enough to provide much shelter from a sour economy.

On the other hand, if you applied the entire $500 to your card debt, you'd pay it off in less than a year and lower your interest charges to about $370, saving more than $2,000. And you'd reach your savings goal several months earlier.

What to do

Unless you're about to lose your job, focus on paying off your credit-card debt. If you need to charge purchases, use a different card with no balance so you still have an interest-free grace period, and charge no more than you can pay off every month. Or switch to a debit card or cash.

In an emergency, you can use your credit cards, assuming, as Orman points out, that the banks haven't gutted your borrowing power. Or you can borrow on a home-equity line of credit if you have one or can qualify for one.

This article appeared in Consumer Reports Money Adviser.


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