Having adequate savings is critical to maintaining financial health. Here are the four key considerations to create a robust and effective saving strategy, plus a primer on common savings instruments that can help you reach your personal goals. By Michael Norton, MD, MBA, FASA
Recently, I wrote about credit cards and talked about some ways to spend money in a manner that’s both smart and profitable. Now I’m going to pivot and focus on the opposite side of things: saving. Having adequate savings is critical to maintaining financial health. It facilitates large purchases (such as furniture, vacations, or even vehicles) without incurring huge amounts of debt and acts as a safeguard in the event of emergency expenses. Unfortunately, it’s estimated that nearly 50% of Americans have inadequate savings to pay for unexpected medical bills or car repairs. Even more worrisome is that around 25% of Americans are estimated to have no savings at all! In this post, I’ll discuss how to create a robust and effective saving strategy. I’ll also talk about some of the different savings instruments offered by banks and compare their features.
4 Steps to Making a Savings Plan
Step 1: Understand where you stand financially. Do a thorough financial inventory, making a list of both your assets (especially liquid assets) and liabilities. Assets may include bank accounts, certificates of deposit, retirement and other investment accounts, and cash on hand. Other valuable assets, such as real estate and vehicles, are often much less liquid and therefore not as useful in making financial space for saving. Liabilities, on the other hand, include any loans you may have, credit cards, bills, and other payment obligations.
Step 2: Determine your savings goals. What do you want to save for, and over what period of time? Savings accounts may be used for either short- or long-term monetary requirements. For example, you may wish to have an emergency fund containing two or three times your monthly income. Or you may want to put money away specifically earmarked for vacations or home improvement projects. It could be beneficial to save up throughout the year for recurring large expenses like car insurance so they don’t hit your monthly budget hard when they come due. If you’re looking way down the road, retirement savings and funds for the kids’ college expenses may be on your mind. Whatever your savings goals are, make sure they’re SMART: specific, measurable, achievable, realistic, and time-bound.
Step 3: Determine how much to allocate toward each goal. Savings plans only work when you adhere to them, so check your budget to determine how much money you have readily available for saving each month. If you want to put away $3,000 for vacation and $12,000 for emergencies over the course of the year, for instance, you’ll need to have $1,250 of excess money each month: $250 for your vacation fund and $1,000 for your emergency savings. If you don’t have that much, you can check your budget for ways that you can decrease your expenditures, or you can look into a side hustle. If neither is an option, you may need to go back to the drawing board and adjust your goals. It's also possible that you’ll have fluctuating amounts of extra cash each month, either because of income variability or major expenses at specific times. In that case, adjust the amount of money you’ll save each month to account for that variation and make sure the total is enough to meet your goal in the desired timeframe. The important thing here is to plan ahead and determine those amounts in advance!
Step 4: Decide where to put the money you save. Since inflation will devalue your savings over time, you’ll want to choose savings destinations that offer the maximum possible rate of return while delivering the access to your money that you require. For example, an account that’s used to spread large expenses over the whole year doesn’t need to grow much since inflation will presumably limit its devaluation over a single year, and it needs to be highly accessible. On the other hand, emergency savings can be a bit less accessible but should grow since you don’t know whether they’ll be used this year, five years from now, or at all. With the remainder of this post, I’ll discuss several savings instruments and compare their features. I’ll skip talking about retirement accounts since those have been discussed a lot in other posts featured in this blog.
Types of savings instruments
Traditional savings account
This is the type of account people most commonly think of when you say the words “savings account,” and they’re the most basic kind of savings account available at most banks and credit unions. They have the advantage of being highly liquid: if you open a traditional savings account with the same institution that you use for checking, you should be able to transfer money straight from one account to the other in a branch, online, or using your bank’s mobile app. Minimum deposits are generally very low, and it’s easy to find accounts that don’t have monthly maintenance fees. Unfortunately, traditional savings accounts usually have very low rates of return (or annual percentage yields) that fail to keep pace with the rate of inflation, even when inflation is at the Fed’s target rate of 1-2% annually. That means the money in these accounts will gradually lose its value. In addition, traditional savings accounts are generally subject to penalties if you make more than six withdrawals in a given month.
Money market account
These accounts are a lot like a hybrid savings-checking account: they allow you to earn interest on deposited funds while allowing you to write checks or access your funds through an ATM. Like traditional savings accounts, they’re widely available at both physical and online banks and credit unions. They offer much better interest rates, however, and often rival high-yield savings accounts in that respect. That higher rate of return doesn’t come for free, though: money market accounts often require a hefty initial deposit and have tiered interest rates, requiring you to maintain a high balance in order to receive the best rates of return. Like traditional savings accounts, they are also subject to financial penalties if you make too many withdrawals in a month.
High-yield savings account
Unlike the preceding types of accounts, high-yield savings accounts aren’t generally available at brick-and-mortar banks and credit unions. Rather, they’re the territory of online institutions that are able to offer the best rates of return by eliminating expensive overhead costs. As such, they’re one of the best ways to maximize your deposited funds’ growth while not incurring the risks of investment accounts, but they do require that depositors be comfortable managing their money without the use of physical bank locations. Like traditional savings and money market accounts, HYSAs are insured by the FDIC (or NCUA, in the case of credit unions), and they’re subject to penalties for excessive monthly withdrawals. However, online banks typically have lower penalties and account maintenance fees than brick-and-mortar institutions.
Certificates of deposit
Certificates of deposit are available from both physical and online banks, and their interest rates may exceed even those of HYSAs. There’s a compromise, though: when you put your money in a CD, you must keep it there for a specified amount of time or face an early withdrawal penalty. Terms for CDs range anywhere from 30 days to 5 years, with the best rates of return corresponding to the longer terms, and at the maturity date of the CD you generally have the option to withdraw your money or roll it into a new CD. Because money invested in CDs is not easily accessible, you may want to avoid them for funds that you may need in a pinch – your emergency savings, for example. Alternatively, by setting several CDs with varying maturity dates, you can retain reasonable access to your savings. (At that point, however, I’d recommend just going for an HYSA and accepting a slightly lower interest rate as a reasonable price to pay for convenience and accessibility.)
However you decide to save your money, it’s important to keep track of it and periodically assess whether there are better or more profitable ways to save. By doing this and sticking to your savings plan, you can maintain a very stable financial base for many years to come.