Getting Comfy with Your Money

Chapter 2:
How Your Money Works

Short-Term Savings
Long-Term Savings
Your Net Worth

Saving is the process of setting aside part of your current income for future use.

The amount that you set aside periodically for a saving plan can be:

  • a percent of an income – a set percentage of the receipts expected from an income;
  • a fixed amount – the same amount each income period;
  • unscheduled – any extra money that is not needed for any other purpose.

The reason for saving your money can be anything. The intended use of a saving plan can be short-term or long-term.

Short-Term Savings

A short-term savings plan is meant to accumulate money for an immediate need. The money in short-term savings is kept in your checking account for quick access. Earning interest on short-term savings (above what may accrue if your checking account is interest bearing) is normally not a concern.

Emergency Fund

An emergency fund is money you set aside to pay for unexpected expenses such as:

  • Unforeseen medical bills
  • Home appliance repair or replacement
  • Plumbing issues
  • Car repairs

The amount of your emergency fund depends on your comfort level, which may change as you gain experience managing your household finances. When starting out, $500 may be enough. As soon as you can, begin increasing your emergency fund to $1,000.

As your income grows and your lifestyle improves, continue increasing your emergency fund. Having money on hand for emergencies that is equivalent to three to six months of your expenses is a goal that will keep your emergency fund in sync with your income.

Resist the temptation to use the money in your emergency fund for non-emergency purposes. While having your emergency fund immediately available in your checking account is optimal, moving the money to another checking or savings account is a way to avoid spontaneous, unadvised uses of your financial safety net.

Periodic Savings

A periodic savings is used to pay a large expense that is predictable in both the amount and frequency. Examples could include:

  • Renewal of vehicle tags
  • Quarterly estimated income tax payments
  • An annual HVAC maintenance contract
  • Annual preparation of tax returns
  • Having the gutters cleaned each year after the leaves stop falling

A periodic savings plan spreads the cost of a large expense over as much time as possible, thereby reducing the impact of the large expense on your income stream.

The set-aside amount for a periodic savings is the expected amount of the expense divided by the number of set-aside opportunities before the expense comes due. For example:

An annual prepaid service agreement for HVAC equipment costs $370.00. The contract is paid in full on March 1st each year. Accumulating the full payment over 12 months is done by setting aside $30.83 ($370 / 12) per month in a periodic saving plan.

Ongoing Savings

Ongoing expenses are expected, but when they will happen or how much they will cost is not yet known. Examples could include:

  • Auto maintenance (e.g., regular service, new battery, minor repairs)
  • Home repairs (e.g., leaky faucet, clogged drain, broken window)
  • Seasonal landscaping work
  • Entertainment (e.g., concerts, movie premiers, tulip festivals)

An ongoing savings plan smooths the impact on your income stream of a known and possibly large expense that will happen sporadically.

Ongoing saving plans can be either perpetual or limited.

  • The set-aside amount for perpetual ongoing savings is calculated by dividing the total of the estimated annual expenses by the number of set-aside opportunities in a year. The amount of accumulated savings in the plan is allowed to grow without limitation other than withdrawals to pay an expense.

  • The set-aside amount for limited ongoing savings is calculated the same as for a perpetual ongoing saving plan. The difference is that there is a limit on the total accumulated money. When the amount in an ongoing savings is at the limit amount, no further money is set aside until you make a withdrawal to pay an expense. The set-asides are then resumed until the money in the ongoing saving plan again reaches the plan limit.

A perpetual ongoing savings plan works well when the amount of the expense can fluctuate unpredictably, or when you are setting up a new ongoing saving plan and cannot, with reasonable accuracy, predict the total annual cost.

Limited ongoing saving plans are best for annual expenses that have a fairly well-known cost but may not happen every year. Eye exams and glasses are an example.

Short-term saving plans can be switched between perpetual and limited at any time as circumstances indicate.

Long-Term Savings

Setting aside money in a long-term savings plan is how you reach a large future goal, like building wealth, as well as prepare for events, such as retirement.

An in-depth look at the myriad ways to grow your long-term savings is beyond the scope of this book. There are many books, courses, and financial advisors available to help you along your path to building wealth and ensuring a secure retirement. The intent here is to introduce to you a few basic investing concepts so that you have an idea of where to start working toward your long-term goals once you become comfortable with your money.

Putting Your Money to Work

The money you set aside in a long-term savings plan is not kept in your checking account. Instead, you put your money in other types of accounts and investments to take advantage of value growth, simple interest, and compound interest to grow your savings as quickly as possible.

  • Value growth – There are two categories of company stocks and investing styles. Value investors look for stocks they believe are undervalued by the market (value stocks), while growth investors prefer stocks that they think will deliver better-than-average returns (growth stocks).

  • Simple interest – Interest on a savings account is calculated using the total of deposits into the account. Interest earned in previous periods is not included in the calculation of interest for the current period.

  • Compounding interest – Interest on a savings account for the current period is calculated on the total of deposits into the account, plus all accumulated interest from previous periods. The balance in a savings account that compounds interest grows much faster than the balance in a simple interest account.

Using Gross and Net Income

You can set aside part of your gross or net income for long-term savings. Here are a few examples of both approaches.

  • Employee Savings Plans (ESP) – An employee savings plan is a pooled investment account provided by an employer that allows employees to set aside a portion of their pre-tax wages for retirement savings or other long-term goals, such as paying for college tuition or purchasing a home. Many employers match their employees’ contributions up to a certain dollar amount, or by a certain percentage. The most popular ESP in the U.S. is the 401(k) retirement plan.

    Participating in an employer’s savings plan is attractive because you don’t see your pre-tax contribution in your paycheck, the employer’s matching funds is extra income, and there are tax advantages.

  • Individual Retirement Account (IRA) – Popular tax-deferred savings accounts for net income are traditional, Roth, SEP, and SIMPLE IRAs. An IRA allows you to save money for retirement with tax-free growth or on a tax-deferred basis. An IRA can be set up at a bank, credit union, or financial institution. Withdrawing money before age 59-and-a-half normally costs a 10 percent penalty. There are income limitations for contributing to Roth IRAs and for deducting contributions to traditional IRAs.

    For current information on IRAs as well as other tax-deferred saving options, visit your bank or credit union, or talk with a financial advisor.

  • Investing – Investing is the act of allocating resources, usually money, with the expectation of generating an income or profit. You can invest in endeavors, such as using money to start a business, or in assets, such as purchasing stock or real estate in hopes of reselling it later at a higher price.

    Growing your net income by investing in stocks, bonds, and property comes with risk. The money you invest may grow, but your investments can also decrease in value. The best edge for minimizing your risk and successfully building wealth is to learn all you can about your chosen investment path and to seek advice from accredited financial advisors.

    Starting to invest does not require a great deal of money as is commonly believed. As with any savings program, you can start small and build on your portfolio (all of your investments). The sooner you get started, the longer your investments will have to grow.

Automating Your Plan

Consistently putting money aside in your long-term saving plan is essential to achieving as much value growth as possible. Being consistent with deposits to your plan is much easier when you are not involved in the process. Options for automatic monetary transactions let you put your long-term savings plan on full automatic so that deposits to your investments happen whether or not you remember.

Money that you put into an employer savings plan is contributed automatically from your gross income by the employer. The deposits are made at the same time that you get your paycheck. Sticking with such an automatic plan is easy because of its transparency.

The plans that you have for saving from your net income can also be automated. You will see the money before it is added to your savings plans, but automatic contributions to your savings that happen without you having to do anything helps keep you on track.

Set-asides of your net income to your long-term savings plans can be done with automatic transfers or withdrawals.

  • Automatic Transfers - Banks and credit unions offer automatic transfers that you can set up to move an amount of money from your checking account to another of your accounts on a fixed schedule.

  • Automatic Withdrawals - Financial institutions, such as investment brokers, will automatically withdraw an amount of money from your checking account to your investment account on a preset schedule.

Your Net Worth

The measurement you use to monitor your financial health is your net worth. Net worth is the value of all the assets you own, minus all of the liabilities that you owe. For example, consider a couple with the following assets:

  • Primary residence valued at $250,000
  • An investment portfolio with a market value of $100,000
  • Automobiles and other personal assets valued at $25,000

Their liabilities include:

  • An outstanding mortgage balance of $100,000
  • A car loan of $10,000

The couple’s current net worth is calculated as:

    ($250,000 + $100,000 + $25,000) – ($100,000 + $10,000) = $265,000

Your net worth will change over time. Ideally, the value of your assets will increase while your liabilities decrease. You keep track of how your finances are changing by updating your net worth. How often you update your net worth depends on how quickly your finances change.

The Net Worth page in Income Companion is where you can build and save your balance sheet. To update, you edit those values that have changed as well as add and delete items. The program automatically keeps your net worth history, which you can chart by clicking one button.

Click here to enlarge the image.

When applying for a new credit account, you can provide your current net worth by:

  • clicking on the “copy page” link;
  • pasting the copy of the page into an email and sending it to the lender.

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