Can you cover the cost of a new refrigerator if yours were to break tomorrow? What’s your plan if the engine in your car goes up in smoke on the commute to work tomorrow? Are you going to end up with a giant credit card bill that you won’t be able to pay off the next month? Will you be stuck eating ramen noodles and mac ‘n cheese like your college days?
I talk a lot about saving for retirement and investing for the long-term on this site, but one of the most important aspects of our financial lives is our short-term savings.
Short-term savings is more commonly referred to as an “emergency fund” but the truth is, your short-term savings is much more than just an emergency fund. It includes everyday savings goals such as planning a vacation, or saving up for that new 72″ TV!
How much short-term savings do I need?
The first step to determining how much you should stash away for the short-term is to calculate what your monthly expenses are. If you use a service like Mint.com or Personal Capital (as I highly recommend that you do) to track your finances, your monthly spend will be just a click away. Whatever you use to track your spending, take a sampling of a few months worth of spending to get an average of what you usually spend per month. (I’ve been using Mint forever so I usually take 12-18 months worth of spending to calculate.)
Another thing I like to do is to add in an extra $1-200 to this number just to give myself a little extra buffer in my calculations.
Once you have your average monthly spending, consider a major life setback (job loss, major injury etc…) and determine how many months worth of living expenses you think you should be able to cover if that event should occur. Now multiply your monthly spending number by the number of months you want to keep on hand (typically 3-6) and viola! You have the amount of money you should be keeping as your emergency fund. Keep your emergency fund in a liquid account. Someplace like a savings or money market account. Don’t even think about investing this money in the stock market!
Note: 3-6 months is the typical generic advice for this number, I keep 3 months because I’m a bit of a gambler. My girlfriend keeps more than 12 months because she’s a bit of a worrier. Only you can determine exactly what number you’re comfortable with.
Looking Beyond Emergencies
Your emergency fund is only the base of your short-term savings. The next step is to take a look out into the near future. Are you planning to remodel your kitchen? Taking a trip to Europe? Replacing your beater of a car?
Whatever the big expense you have planned is, estimate how much it will cost and approximately when it will occur.
If you don’t have the money saved for this event yet, figure out how much you need to stash away each month to hit your goal on time and automate it. Set up a recurring transfer each month so that you treat this savings goal like any other bill you have to pay (after you have enough put away in your emergency fund of course!)
Again, this is money you’ll need access to in the near-term. So the stock market is out of the question. Most likely this should also be kept in a high-yield savings account or money market account. But if your savings goal is a little further out, say 2-4 years. You can try to get a little more bang for your buck by using a less liquid type of account. Such as a short-term CD or a P2P lending account.
Make it a Habit!
I actually have two savings accounts. One for my emergency fund which hopefully I’ll never have to touch, and another that acts as a place for my short-term savings goals and as a feeder for my other investment accounts.
You don’t necessarily need two accounts, but you do need to make your saving a habit. I’ve mentioned several times how big a fan I am of automating the whole process. It takes the temptation to stray off course completely out of the equation.
Once you have your emergency fund funded and are saving towards your other short-term savings goals you can start thinking about funneling some money into the stock market. The stock market is a volatile place and you shouldn’t put any money you need in the near-term at risk by investing it in the markets.
What are your short-term savings goals? How many months of expenses do you keep in an emergency fund?