Although there may be multiple variations and investment options, there are generally only four types of savings: emergency reserve fund, accumulation fund, long-term investments, and college education savings. However, in this article we will address only the first three.
An emergency reserve fund is to be used for emergencies and then replenished. An accumulation fund is one that can be used for unexpected large expenses or for major purchases. Long-term investments are primarily designed for family security, inheritance, and retirement.
Emergency reserve fund
An emergency reserve account is not part of an accumulation fund or long-term investment portfolio and should be handled differently. Each family should have an emergency reserve fund set aside for emergencies. Regardless of their financial state, every family can afford to set aside something. Even as little as $5 per week will accumulate. An emergency reserve goal should be the maintenance of an amount equal to at least three months' income and preferably six months' income. Whenever the fund is used for emergencies, the amount withdrawn should be replenished as soon as possible.
The emergency reserve fund should be placed where the money is absolutely safe and can be easily converted to cash without an early withdrawal penalty. There are three primary options for housing an emergency reserve account: banks, credit unions, and money market mutual funds.
- Banks. Local banks are the most convenient of the three, but they usually pay less interest on your savings. Banks offer a number of savings options that you might want to consider. Some of the most popular are passbook savings, NOW accounts (must maintain a minimum deposit of $1,000), SuperNOW accounts (must maintain a minimum deposit of $2,500), Certificates of deposit (CDs), and bank money market accounts (these are not to be confused with money market mutual funds).
- Credit Unions. Credit unions are excellent bank substitutes that typically give good value on your money and are just as safe as banks. Most credit unions offer the same or similar savings options offered by banks but usually offered at a slightly higher interest rate.
- Money market mutual funds. Money market mutual funds usually pay from 1 to 2 percent higher interest than banks or credit unions. They also offer a check writing privilege option, and they are as safe as banks.
Liquidity is not as important as higher returnsAn accumulation fund is, in effect, a long-term emergency fund. It can cover unexpected major expenses or large purchases. An accumulation fund allows you to have a longer time frame in mind--anywhere from one to five years before you'll need the money. Because you plan to leave the money in the account for one to five years, liquidity is not as important as higher returns. The four most popular investment options for accumulation funds are certificates of deposit (CDs), ultra short-term bond funds, short-term bonds, and mortgage-backed bond funds.
- Certificates of deposit (CDs). CDs offer safety and reasonable returns but lack flexibility due to early withdrawal penalties. Shop statewide or nationwide in order to get the best rates.
- Ultra short-term bond funds. If you won't need your money for six months to a year, you might want to consider ultra short-term bond funds. These funds typically have very low volatility and pay a reasonable rate.
- Short-term bond funds. If you won't need your money for two to three years, short-term bond funds offer the potential for better returns at a slight increase in volatility.
- Mortgage-backed bond funds. If you won't need your money for four or more years, you might want to consider mortgage-backed bond funds, such as Ginnie Maes. They offer attractive yields and pay monthly dividends, which you can reinvest in more shares.
The three primary reasons for long-term investing is to help your family achieve a greater degree of security, provide an inheritance for your family, and fund retirement. Long-term investments are not intended to be short-term get-rich-quick programs. They are exactly what they say they are--investments meant to last and grow for years to come.
Long-term investments need to be diversified into five tiers if at all possible.
- Tier one. Secure income investments, such as government securities.
- Tier two. Long-term income investments. These are investments that are higher risks but have a higher rate of return, such as municipal bonds, mortgages, corporate bonds, insurance annuities, stock dividends, and money funds.
- Tier three. Growth investments such as undeveloped land, housing, and balanced mutual funds.
- Tier four. Speculative investments such as common stocks/aggressive growth mutual funds, and precious metal options.
- Tier five. High-risk investments, such as gold and silver, oil and gas, commodities, collectibles, precious gems, and limited partnerships.
As a general rule, only 5 to 10 percent of your investments should be in cash, or near-cash, investments. These include bonds, certificates of deposit, Treasury bills, and money market funds. In addition, no more than 5 to 10 percent should be invested in high-risk investment, if at all.
Along with discipline and maintaining a budget, saving is the best way to prevent being encumbered by debt. Establishing an emergency reserve account should be the first savings consideration. After this account is in place, accumulation funds and long-term investment can be considered.
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