Note: Although the information written several years ago, the ideas behind the information remains the same. Short-term savings goals are often the most difficult. Savings accounts, CD or Certificates of Deposit, Money Market Accounts are great short-term savings vehicles. But so are savings bonds, mutual funds, and 529 plans.
Additional information can be found at our personal finance and retirement planning site.
I have received some interesting feedback about savings since the last time I was on the AM NorthWest (02.22.05). They have ranged from "how do I save for the short term" to "savings are irrelevant!".
That last person argued the measure of savings in this country - remember I mentioned last time that the Commerce Department reported a savings rate of .01% or a penny on the dollar - is all wrong. He said all those reports about mutual fund inflows and IRA companies and 401(k) plans have to be getting the money from somewhere. And they are. So that penny on the dollar I told you about is based on monthly after-tax income -which excludes 401(k) participation, focusing more specifically wages, dividends, interest, rents and employer contributions to pensions, and then, that number is subtracted from expenses or, using accounting lingo, expenditures.
Some economists and the guy who wrote me want me to make clear that Americans are saving even if the Commerce Department is missing all the stats. They want household worth to measured as well which means that spending the house is okay if you feel wealthy because your house has a large heap of equity.
Which may be why the dream of the American home has intensified with the help of some very accommodative interest rates.
Short Term Savings Goals
We had previously discussed ways to painlessly develop some long term savings habits using tax refunds and 401(k) plans. More than one email wanted to how to save for something a little closer, like a home or their kid's college tuition.
Saving for either of these goals is no easy accomplishment. Some of us have already saved quite a lot if we are using our 401(k) plans or IRAs to their fullest. Those tax deferred accounts such as a 401(k) or a traditional IRA - tax deferred means you pay the taxes when you begin to withdraw the money - can be used towards a home as well.
You are allowed a one time, penalty free withdrawal of those funds to buy a house, finance a college education, or pay for a major medical expense. This is not necessarily the wisest choice however, even if owning a home is a very enticing proposition. This money is your retirement and really should be left there.
For quite a few years after buying the house, your ability to save those kinds of funds may be inhibited by what is often called "a hole in the ground you throw money into". So leave the retirement savings where it is.
Saving to buy a house usually means saving enough for a down payment. I'm sort of old fashioned that way disagreeing with a lot of the new financing methods available to new home buyers. I would love to see folks save for a down payment, which is good practice towards actually practicing to pay a mortgage.
Buying a house will, if you are a two income couple, eat more than one half of your total combined income. It is just the way it works. A 200,000 home at 6% will cost you roughly $1,200 a month in just mortgage payments. That does not include insurance or taxes which can quickly get that bill up to over $1600 a month. A couple earning a combined income of $48,000 only has about $3500 in disposable income after taxes. That's why I want you to save half of your household income for six months prior to searching for a house.
So it is important to understand that buying a home will cost you one income to cover one fixed part of the bills. From the other income, live like a college student paying the rent and all of the rest of the bills. Sound hard? It is, but it is good practice for those tough homeowner days ahead.
The average home price in the Portland metropolitan area, based on 2004 sales numbers is $203,000. That is up from 2003 numbers by $18,000. That is a huge increase in price and that is the wealth effect that I spoke about earlier. Whether it should be counted on as real wealth is debatable but nonetheless, for someone beginning to search for a house, they believe the longer they wait, the worse their chances at getting in on the housing boom. And the sooner they can get in, the quicker the value of their home will increase.
Some folks have compared the recent rise in home prices as comparable to the recent stock market bubble and there are some similarities. Easy money is the most obvious. But rather than chase easy money, try and live on one income for six months. If you are renting, the payment you make should come out of the other person's income for the savings period. Why six months. According to most house hunters in the area, that is the average amount of time spent looking.
Even using resources like PortlandMaps.com, there are a lot of houses to consider and a great many considerations to be made. We'll save that for another show. So during that period, you live below your usual income level. It is sort of a survivalist test. the financial fittest will be the best ones to adapt to the little problems that are no longer your landlords - they are yours to deal with and pay for!
Where to Stash that Short Term Cash
The goal is to protect the principal and of course, live like a student until you save enough for the down payment.
Savings Accounts will begin to offer higher savings rates and some online banks are offering incredible rates with a certain balance, usually pretty high for beginner savers but they offer better rates overall because they are virtual - without walls to pay for, they tend to offer better rates. Be sure to have all of your firewalls and security software in place and all of the necessary encryption in your wireless network.
Because of the low interest rates paid by banks, savings and loans or credit unions, many people shy away from using these accounts in the short term. That's too bad. They do add a little peace of mind for some savers who want only slightly better than beneath the mattress.
As little risk as possible for your principal which, for such specific goals, is a good thing. Interest rates will improve at these institutions as the interest rate, the one you hear about on television so often, rises. The FDIC insures these accounts up to $100,000 as well so your cash is safe and it is easy to get to when you need it. But at 0.64% with a yield around 1.5%, you don't beat inflation.
Certificates of Deposit or (CDs) are basically notes with a fixed maturity date and a fixed interest rate. For instance, a six month CD has been holding around 2.46% but you can check sites such as BankRate.com for up to the minute changes in yields on sorts of short and longer term notes. I've seen them as high as 3.25% recently here in Oregon, which is a pretty return for your efforts and up from about 1.72% just six months ago. These are perfect for someone who is looking to protect their cash in the short term. These are also insured up to $100,000 and are perfect for those looking to save money with a specific goal in mind.
Money Market Accounts/Money Market Mutual Funds also have some of the guarantees bank accounts and CDs have but tend to offer higher interest rates as well. Truth is, what you should be looking for in Money market Accounts is frequency of compounding. Some do it more often, like once a month. Some do it every quarter. In this case, doing it often is beneficial.
Money Market Accounts are issued by banks so they have the first $100,000 protected while Money Market Mutual Funds are used by brokers for the short term. These may offer none of the bank guarantees but the money is, for the most part, safe. There were some scary moments in the late 80.'s and early 90's but these funds guaranteed that a dollar was still a dollar. But rates have risen dramatically in the last six months. Start now and watch those savings grow. At a national average using monthly compounding, a $1,000 initial deposit and a monthly deposit of a $1,000 at 3.25% over twelve months grows by $213. Okay, that's not so impressive but these instruments often have check writing privileges often limited to a certain amount per month and not to be used for, say, small purchases like a run to the grocery store, and are overall good places to park money other than regular savings or checking.
Brokers often use these to park money until the investor is ready to invest.
In many 401(k) plans, this is the default investment - which is not a good thing. In those plans used for retirement, you want your money to work, not be protected and risk free. Okay for some of your savings but not all of it if the goal is long term. Short term though, these types of accounts are excellent.
You should save every spare penny, half of your household income for at least six months, longer if possible. But if neither of you have attended college, putting one of you through four years will net you more lifetime income than not and the chances of a bigger house. That's just the Dad in me talking.
For College, a Different Approach
First, a simple rule of thumb based on household income. If you make $80,000 a year or more, there will be far fewer opportunities for you and your child to get financial aid. Aid is usually based on need and the ability to pay. Families making that much or more should look into a regular savings program such as a 529 plan or use some of the suggestions I'm about to make. They serve the same purpose and are better tailored for a short horizon.
But those who make less than $80,000 may find the money better spent on raising the child during the lifetime of the child. I call it building a better person. The costs of extra curricular activities during the primary and high school years such as paying for music and dance lesson, sports, other classes to improve themselves, etc. tend to provide undue pressure on the average wage earner. Trying to save money for college as well, while sacrificing your retirement can be doubly difficult for this group.
Financial aid as I said, is based on the need, the family assets - or the expected family contribution to the tuition - and the amount of scholarships and grants the student has earned. These are advantages that allow for you to continue to fund your retirement, make a house payment, stay out of the poorhouse and send your kid to college.
Some parents who can contribute to a regular plan have found funding for college to be a jungle as well. For such a short term goal, risk plays an important role. Too much and you can risk the principal. Too little and you worry you won't be able to afford it.
U.S. Savings Bonds carry the full faith and credit of the Federal government and are loved by grandparents everywhere. They can earn interest every six months and can be bought in amounts as small as fifty dollars. You can walk into any bank and pay cash for them and the interest rate, which is market based, begins right away. The longer you hold them the better the interest rate return. A thousand dollar Series EE bond will get you about $175 in five years. Not too bad and the Series I bond has beat inflation for the last twelve years.
There are three types of bonds with different advantages but the benefits are clear. Suppose Grandpa Joe buys a Savings bond for a $1,000.00. At 2.00% with a monthly investment of $100.00 and 15 years, after federal taxes (say 28%) your investment would be worth $21,391. Use them for college and the bond would be worth $1200 more. That's about 3.03% return when used for college. (Calculate your savings bond return here.)
Mutual Funds can be used to buy money market accounts as I mentioned earlier or government securities such as Treasury notes. Mutual funds are run by a professional money manager who is able to pick from a variety of investment options protecting your money while growing it - even if slightly.
Mutual funds are usually found in retirement plans and can have stocks or bonds or both in them. For the short term saver, these may be too risky. If your retirement account has been well funded by you and you want to use that money to purchase a house or pay fro your child's college, you can take advantage of a one time withdrawal of funds, penalty free to do so. Penalties usually apply to accounts that are tax deferred. Think long term.
Stay away from Individual Corporate Bonds or Stocks for short term goals. This type of investment is too closely tied to the fate of the markets and the companies in them.
And finally, there are U.S. Treasury Securities (Treasury Bills, Notes, or Bonds). These are fixed income investments with specific time frames. They can be as short as 13 weeks or as long as 30 years. Interest rates can be affected by numerous events but the principle is protected. These are still best invested in a mutual fund where a manager can spread the risk over a series of purchases.
Thinking about 529 Plans?
And just briefly, here are some of the highlights of a 529 plan, a college savings plan usually administered by an investment firm. Every state, I believe, now has some sort of plan. Here is how they work:
Your get great tax breaks,
The account is in your name with the beneficiary only getting the money when you decide.
They are easy to invest in and
you can put up to $230,000 a year away in the accounts
They do however,
count against your assets when applying for aid,
but can be transferred, sometimes at a slight loss, to other schools outside of your state.
There are some serious tax consequences if your student does not go to school and
many of the rules governing 529 plans can change from state to state.
Colleges online can be a great way to cut costs, although saving will be necessary.