Economics on the small scale

Wednesday, March 29, 2006

How to Save For an Emergency:

Jonathan [Pond] via Andrew Tobias writes:
Worst advice from your parents: ‘The first thing you should do when you start your first job is to put a year’s worth of income in a savings account in case of a financial emergency.’ An obedient child then spent the next 14 years adding savings to the emergency account, all the while earning 2%. Best advice from your parents (probably given when you were an adolescent): ‘For one moment’s pleasure, you could end up paying for the rest of your life.’ While at the time you may have thought they were talking about something else, they were actually talking about credit cards.”

I like the 'Best advice' quip, but I don't think he's entirely correct about savings accounts.

It's much easier to save when you can put money in a separate account from your main bill-paying account.

And while I ditched my savings account a long time ago in favor of a Money Market Account, a Money Market Account requires a substantial minimum balance. A savings account's minimum balance is usually a magnitude smaller if there's one at all.

A Savings account is really just a staging place to accumulate enough money to buy 3 month CDs (Certificates of Deposit). CDs are where you should park your Emergency money.

I have three 3 month CDs; each maturing one month after the other. If I have a financial emergency, I'm likely to have one that I can withdraw penalty-free. If I need to tap all three, the penalty (forfeiting interest earned since last maturity) isn't all that large.

You're not going to get rich stashing Emergency Money in CDs; but the slightly higher interest you earn on CDs helps keep your Emergency fund constant on an after-inflation basis.

As to the amount you stash away -forever, hopefully- A year's worth of income is ridiculous. Base it on your likely emergency expenses such as replacing your car or paying your bills while out of work for a few months.


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