Savings: Why Is It Important?

Introduction

Savings are defined as income not spent. All financial plans should include an income plan that does not require paying bills and debts. These additional funds can be used for investments, charity, and savings. In this section, we'll discuss Savings and why it is one of the pillars of personal finance.

Savings are money set for a specific purpose to be used shortly, which must be gotten very quickly and must also be kept somewhere safe. The types of savings I'll discuss should never be put into an investment, as there is a chance that you may lose some or all of the value by the time you need to have it available. Suppose your savings are in investments, and when you need them, they are down. In that case, you may be tempted to put the expense on credit in hopes that the investments will return to the level they were when you initially invested them or even wait until they gain in value.

What is Savings used for?

There are many purposes for saving money. Let's go over the reasons you might save money.

Emergency Fund

An Emergency Fund (or rainy day fund) covers life's unexpected events. Be it a broken hot water heater, a dead battery on your car, getting sick or hurt, and ending up with large medical bills. Life is full of unexpected events. Some of them have a cost associated with them. These financial events cause stress and worry at a time when you don't need any more stress and worry.

Without an emergency fund to cover these financial events, you will likely put the cost onto a credit card, which adds debt and more stress and worry. Having an Emergency Fund alleviates some or all of the stress and worry.

If you don't already have an Emergency Fund, it should be the first type of savings you begin. Even a tiny emergency fund of $700 can cover any unexpected event. A fully funded Emergency Fund should be between 3 to 6 months of expenses so that you can cover something as harsh as a job loss.

Vacations

This is a great reason to save money. A vacation is much more enjoyable when you know you won't have accumulated additional debt from being on holiday when you get home. Vacations are meant to be relaxing, and saving them removes an extra layer of stress you didn't know was there.

Vehicles

For most people, the need for a vehicle is a way of life. Vehicles are expenses that lose value the more you use them, so you will never recoup the purchase cost (collectibles may be the exception, but that will be covered in another article). Saving up for a car also brings the same savings as saving for a vacation. In my family, we have paid cash for cars and made payments.

If you know a car purchase is coming, you should save the amount of the payment each month into a savings account. This way, when you need the car, you will have/most/all of the price of the vehicle. If it is some/most, then you will have paid down the cost of the car, and the payments can be lower for a shorter term.

Once the vehicle is paid for, if your budget can support it, I recommend keeping the payment in savings. This way, you will likely have the full purchase amount saved for when the next vehicle purchase is needed.

Down Payment on a Mortgage

The price of a home (property) is typically so large that it is tough to save up to pay for it in full. At least, this is the case for your first purchase. Saving up as much as possible in a savings account for your down payment has many benefits, depending on the amount you have saved. Also, different types of mortgages have different requirements for downpayment.

Mortgages provided by the Veteran Affairs (VA) or the US Department of Agriculture (USDA) typically do not require any downpayment to qualify for the mortgage. This is great for those serving in the military, veterans, or spouses of veterans (for the VA,) and those in rural locations (USDA). Please note that without the down payment requirements, these loans typically have a higher interest rate than what is available on the open market.

Other types of mortgages include those provided by the Federal Housing Authority (FHA) and conventional loans. The federal government guarantees FHA loans, while traditional loans do not. Conventional loans can also purchase a second home or investment property.

The FHA loan requires a minimum of 3.5% down payment. On a house costing $150,000, the down payment at 3.5% would be $5,250. With an FHA loan also comes mortgage insurance. Mortgage insurance is protection for the lender, paid by you, the borrower, to protect the lender from you defaulting on the property. When a property has been defaulted on, the payments were not made according to the mortgage agreement, and the bank foreclosed on the property. With an FHA loan, mortgage insurance is added to the loan, regardless of the amount put down on the property. If you put less than 10% down on the property, you will pay mortgage insurance for the life of the loan. If you put down 10% or more on the property, you will pay mortgage insurance for 11 years.

Conventional loans require a minimum downpayment of 3%. However, it is recommended that you put at least 20% down. If you put down less than 20%, you will be required to pay private mortgage insurance (PMI) until you own 78% of the equity in the home. If you put down at least 20%, PMI is never added to the mortgage.

Saving for a 20% down payment can be very overwhelming. One tactic is to purchase your first home with as low a mortgage balance as possible and pay as aggressively. Depending on market conditions, you can sell the home in 5 or so years and turn a profit on the home. Use the money made on selling the first home to put a downpayment on your next home. This way, you can reach the 20% down payment level. Again, this depends on the value of the following home at the time of purchase. Shoot for the low mortgage balance again so that any profit from selling the first home reaches 20% down or more.

Investing

When most people think of investing, they imagine long-term investments in a 401k or IRA. However, this usually entails making incremental investments regularly and systematically over the same period.

One of the most popular and lucrative methods of investing is through the purchase of rental property, either residential or commercial. As discussed in the previous section in "Downpayment on a Mortgage," a large sum of money is needed. With an investment property, you will be using a conventional mortgage, which requires at least 3%, but you should aim for 20% to prevent the cost of PMI. Paying more than necessary on any type of rental property cuts into the profits it takes, and thus, your return on investment is lessened.

Large Purchases

In our family, a large purchase is anything over $500. The large purchase would also likely be a want instead of a need. An example is a brick and stone patio I want to install in the backyard. I've tried to do this myself, but it has not been completed in many years. I must have it done professionally for it to be completed and done right. I will then get some pricing from local contractors, letting them know that I plan to save up for this work to be done. Once I know the full price, I can plan my savings accordingly. Being able to pay for something like this is very fulfilling and makes the purchase enjoyable.

Other significant purchases include ATV recreational vehicles such as 4-wheelers or dirt bikes, a bass boat for fishing trips, or a deck added to your home. The sky's the limit for these purchases. These are what I imagine. Leave a comment below on what you would save up to purchase.

Lump-Sum Payoffs

Some types of debts don't allow paying off the extra principal to pay them off faster. They may allow for a lump sum payoff to clear the debt. 401k loans are an example of this type of debt. Let's say you took out a 401k loan for 12,000. Using simple math, your payment, over 5 years (or 60 payments), would be $250 per month. If you could afford to pay $350 monthly, you would put the additional $100 into your monthly savings. On the 35th month, you would have a balance of $3,250 with $3,500 in savings, ultimately allowing you to cut off the loan. This saves you 15 months of additional payments.

Known Future Repairs

If you own a car or a house, you know that repairs are part of ownership. Since we know these costs will come, saving for them in advance makes sense.

For a car, you know that the tires will need replacing and that you will also likely need some mechanical work, such as replacing an alternator. New tires can run between $100 to $300 apiece for a car. To replace them all, you are looking at $400 to $1,200. The replacement of the alternator will cost around $400 for a mechanic to do it (remanufactured alternator). You'll still need around $300 for the part if you do it yourself, but you'll save on the labor.

Replacing a roof, A/C, or furnace in your home can cost upwards of $12,000 or more. A new A/C will set you back about $5,000, and a stove will also be in the $5,000 range.

Since we know these costs will come, it makes sense to start saving for them now so that when they do not, you will be ready to cover some, if not all, of the replacement costs. This type of Savings is called a Sinking Fund and will be discussed in the next section.

Types of Savings

Now that we know why we need to save let's examine the different types of savings. The type of savings is determined by its purposes. There are three basic kinds of savings, and we'll discuss each one in detail.

Emergency Fund

The Emergency Fund, as described above, is there to protect you against the unforeseen that can be addressed with money. From automotive problems to home repairs and job loss, the Emergency Fund must be ready to take on some or all of the financial burden these bring to bear. The money saved in the Emergency Fund is for these purposes and these types alone. It is not to be used for deals or wants. The Emergency Fund is insurance against the unexpected.

As such, the money needs to be saved in a location that can be gotten relatively quickly but not so easily that you can spend it without a hoop or two to jump through. We keep our Emergency Fund in an online savings account connected via ACH to my household account. This way, I can move money between the two electronically, but the move will take a couple of business days to complete. Also, the interest rate paid by the online savings is higher than that paid by my household account. I'm not looking to get rich from the interest earned, but why leave money on the table if you don't have to.

Our Emergency Fund is still being built up, and we've had to use it a couple of times, such as with a new alternator and tires year. We continue to add to it in a scheduled method, and it reaches our goal of about $25,000 at w. Stop the systematic deposits at that point, and I'll continue to grow naturally via monthly interest payments.

Sinking Funds

Sinking Funds are used to save up for known upcoming expenses. You can have one or multiple sinking funds, each earmarked for a different purpose. In my household, we have 2 Sinking Funds.

One is for what we call Big Ticket Items. This is used to save up for braces for my sons. With the money already saved, I could even get a discount on the cs because I could pay the orthodontist cash in full. The other thing we're saving up for is a replacement AC unit. We live in Texas, so our summers are 100+ days long, from June through August. For us, an AC is not a luxury but a necessity. Christmas also falls in this category. We know that it comes each year on December 25th, so we estimate what we will spend and save for it, and we aren't surprised when it begins to arrive. No more paying for Christmas on credit and another. We like to take a nice family vacation every few years. The last one we took was a Disney cruise. I told my wife that we would save up for it ahead of time, and that's what we did. It was delightful to be on vacation, knowing we wouldn't have any debt from the trip to worry about when we went home. As a result of that experience, we have already saved for our next vacation, which will be booked as soon as we know what's happening with COVID-19, vaccinations, and travel/hotels/tourist attractions. With the money already set aside, we can wait for everything to align.

Escrow (Insurance and Taxes)

The last type of savings is for Insurance and Taxes, or Escrow. Some people pay their home's insurance, taxes, and mortgage payment. Payments: Set aside this payment arrangement until they are due. Taxes are due at the end of the calendar year, and insurance can be due at any time of the year to be paid in full. When the bank manages this, it keeps any interest earned on the money. Also, they under-guess the amount due on taxes each year, thus causing the total payment to rise the following year due to the shortfall.

If you can pay your own taxes and insurance because you've got enough equity in the property, you can set the money aside. We determine the cost of our taxes and insurance plus 5-10%. We then take this amount and divide it by 12. Each month, when we make our mortgage payment to the bank, we make an ACH transfer to our Escrow account for the 1/12th of the total figured out above into the online savings account. As the money grows, we earn interest, which is easier to keep. We don't earn much, but all of it is ours. When the taxes are due, we pay them in full. Some years the amount needed for the taxes and insurance exceeds what we've set aside, but only by a couple of hundred dollars. In other years, the required amount has been less than what has been set aside. Either way, it is a very manageable method of pre-saving for a known.

While our taxes and insurance payments may fluctuate yearly, our mortgage payment is locked, making it easier to budget. We can also add money to the Escrow account in a lump sum as soon as it becomes available, allowing us to skip a payment needed to

This was the first type of Savings we made that was not part of our household account, and it has worked well for us for many years.

How to Save

We treat the deposits into our savings like any other bill. We budget for them and schedule the ACH drafts to occur when we want them to. We divide the transfers so that some appear on the first of the month, some in the second half of the month, and some larger ones are split between the first and second parts of the month.

I also used to have a portion of my payment directly deposited into another account when I was paid. I no longer do this, but it worked very well for me in the past, especially before I was married and had only myself to be accountable to. I never even saw the other money hit my account, and I used this method to pay off a vehicle.

We also have a written plan for money that we use with our budget. This plan considers unforeseen extra money coming into our household during the month, such as a tax refund, a stimulus check, a bonus, etc. Because we have a plan, we know exactly where the money will be sent so it does not spill over. As a result of this plan, I could pay off my wife's car over a year and a half early.