Contents
Personal Finance Basics
How to Create a Budget
How to Save Money Effectively
How to Open a Checking Account
How to Manage Credit Cards, Charge Cards, and Debit Cards
How to Invest Your Money
How to Get a Loan
Personal Finance Checklist
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How to Save Money Effectively
Once you’ve mastered the basics of budgeting, you’ll begin to have extra money each month to save and invest. But before you make decisions about how to use this money, you need to know the difference between saving and investing.
Saving vs. Investing
Though people often use the terms interchangeably, saving and investing are very different:
- Saving: Putting away money for a particular purpose, such as the purchase of a car or home. Creating an emergency fund (explained later) is also an important reason to save.
- Investing: Buying specific investment products, such as stocks, bonds, and mutual funds, with the goal of increasing the value of your principal, the original amount of money invested. Investing can also be geared toward specific purposes, such as retirement or college tuition, but the goals for which people invest tend to be far off in the future.
Risk in Saving and Investing
Saving and investing also differ in terms of risk—the chance that your principal might lose value. Since the money you put into savings is meant to be used for a particular purpose in the near future, you cannot put that money at risk. Money that you invest, on the other hand, can tolerate some risk since it most likely won’t be used for a number of years.
Should You Save First or Invest First?
Once you have a monthly surplus of at least 10% of your pretax income, you’re ready to save and then invest. Generally it’s best to do so in the following order:
- Save up an emergency fund: An emergency fund is an amount of cash you keep in a savings account for use in emergency situations, such as a layoff, a prolonged illness, or a death in the family. An emergency fund gives you peace of mind and prevents you from falling into debt when unexpected expenses arise. Most financial advisors suggest that an emergency fund contain six months’ worth of living expenses. Plan to deposit this money into a traditional, FDIC-insured savings account (explained below).
- Save for specific savings goals: A savings goal is the total amount of money that you need to save up in order to be able to afford a specific purchase. For instance, if you’d like to buy a $5,000 engagement ring, your savings goal is $5,000. Your first savings goals should be for essentials, such as a car or furniture. Next, you may want to save for more major goals, such as a down payment on your own home.
- Start investing: Investing is usually the most effective way to build wealth over time. Until you’ve achieved all of your saving goals, typically the only kind of investing you should be doing is investing for retirement through an IRA or a work-sponsored plan, such as a 401(k). Once you’ve achieved your main savings goals, including saving up a down payment for a home, you can start investing your entire monthly surplus, or just a portion of it, if you prefer. For more on investing, see How to Invest Your Money.
How to Set Up a Savings Plan
A savings plan is breakdown of how much of your surplus you need to put into savings each month to achieve your savings goals. If your budget leaves you with a $500 monthly surplus and a $5,000 engagement ring is your sole savings goal, you should plan to put $500 in savings each month for 10 months. If you’re saving for several different goals at once, your plan should subdivide your monthly surplus based on the amount and urgency of each savings goal.
Savings Accounts
The easiest place to keep money that you intend to save is in a savings account. All savings accounts work roughly the same way: you deposit money, it earns interest, and you withdraw it when you need it. Savings accounts are virtually risk-free—they’re insured by the Federal Deposit Insurance Corporation (FDIC), a U.S. government agency established to protect savers from bank failure. If your bank goes out of business for any reason, the FDIC will reimburse you for up to $100,000 per account.
How to Compare Savings Accounts
Though all savings accounts serve the same basic function, they differ in terms of yield, fees, and withdrawal policies.
- Yield: An account’s yield refers to the amount of interest that the bank pays on money deposited in the account. Yield is expressed as an annual percentage. For instance, a savings account with a $1,000 balance and a yield of 4% will earn $40 in interest every year. If two savings accounts are equal in every other way, the account that offers the higher yield is generally the better choice. To compare yields on savings accounts at banks in your area, visit www.bankrate.com.
- Fees: Most banks have low minimum balance requirements for savings accounts (usually $50–100) and charge a monthly fee of $10 or so if your account falls below that amount. Some banks also charge a monthly or annual maintenance fee as well. When shopping for a savings account, look for one that charges no maintenance fees and has a low minimum balance requirement, ideally $500 or less.
- Withdrawal policies: Banks tend to discourage customers from making frequent withdrawals from savings accounts by placing limits on the number of withdrawals that can be made per month. Some banks tout the comparative flexibility of their savings accounts by offering check writing and other features that make their savings accounts function more like checking accounts. If you’d like the freedom to withdraw more often from your savings account, be sure to inquire about withdrawal and check-writing options before you set up an account.
Savings Account Providers
You can set up a savings account at a traditional bank, a credit union, or an online bank.
- Traditional banks: There are three main types of traditional banks—local, regional, and national. Local and regional banks are based in a particular city or region. They tend to have the most personalized customer service but offer lower yields than national banks. Among the largest and most popular national banks are Citibank, Bank of America, Washington Mutual, and Wells Fargo.
- Credit unions: Credit unions are like private banks: to use their services, you first must apply for membership and gain admission. Credit unions tend to offer higher yields than traditional banks, but some also charge monthly or annual membership fees.
- Online banks: Online banks have no branch offices, so you must do all your banking online or by mail. Since online banks have such little overhead, they typically offer the highest yields and the lowest fees.
It’s generally best to use a traditional bank or a credit union, since that way you can visit the bank in person if you have detailed questions or would like to set up another account, such as a checking account. That said, using an online bank can be a great choice if you just need a basic savings account and would like to park your savings in an account with a comparably high yield. Online banks are also a great choice if you live in a rural area or in a location without retail bank branches.
How to Set Up a Savings Account
Setting up an account at any of these financial institutions typically involves filling out a few basic forms with your personal information, including your Social Security number, and making an initial deposit to establish the account, which often can be as little as $1. All U.S.–based savings accounts are FDIC-insured up to $100,000.
Alternatives to Savings Accounts
In addition to savings accounts, there are three other major places to park your savings: CDs, money market funds, and money market deposit accounts.
CDs
Certificates of deposit (CDs) are bank-issued savings certificates that pay a certain fixed yield over a set period of time, called a term. CDs can be issued in any amount and are FDIC-insured for up to $100,000 per CD. In general, the longer the term, the higher the CD’s yield. For instance, if you put $1,000 of your savings into a five-year CD with a 5% yield, you’ll receive 5% of your balance in interest each year for five years, guaranteed. CDs have one major drawback—you can’t withdraw from the CD during the term without incurring a substantial penalty (usually about 10% of the withdrawal amount).
Money Market Funds
Money market funds are a type of mutual fund offered by investment companies and some banks. Money market funds have yields that tend to be somewhat higher than those of savings accounts, but they are not FDIC-insured. Nonetheless, it’s highly unlikely that you’d ever lose money in a money market fund. If you do use money market funds, it’s best to do so at a well-established national bank or investment company, such as Fidelity (www.fidelity.com) or Vanguard (www.vanguard.com).
Money Market Deposit Accounts
Money market deposit accounts are a more restrictive type of savings account. Generally they allow few withdrawals and require a high minimum balance in order to avoid fees. In exchange, they tend to offer slightly higher yields than money market funds, CDs, or traditional savings accounts. They’re also FDIC-insured up to $100,000 per account.
How to Automate Your Savings
The best way to force yourself to stick to your savings plan is to use an automatic deposit plan. These plans automate the process of depositing money into your account each month. To set up a plan:
- If you work for a company: Contact the payroll department to request that an amount equal to your monthly savings goal be deposited directly from your paycheck into your savings account each month.
- If you’re self-employed: Contact your bank to arrange for an automatic monthly transfer from your checking account to your savings account.
Most likely you’ll adjust quickly to having a lower amount of take-home pay and won’t miss the money that goes straight into your savings account. If you find that you don’t adjust, you can always cancel your automatic deposit plan. If you’d prefer to have a bit more flexibility with the money that you deposit automatically, you can choose to direct the money into a checking account, which typically has no limits on monthly withdrawals.
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