Category: Debt

Essential Household Savings Accounts & Why You Need Them

Rainy Day Fund

A rainy day fund is different from an emergency fund–but it is still incredibly helpful for your peace of mind.

A rainy day fund is used for those relatively small and somewhat expected expenses that happen, but you can’t necessarily count on the timing. Imagine that your everyday life is a series of sunny days where you go about your daily life following your routine. Rainy days happen now and then and may disrupt your routine. Sometimes the disruption is welcome; sometimes, it isn’t.

Here are some examples of when you might use your rainy day fund.

Depending on your age and stage of life, you probably find that certain events happen in clusters. Weddings, births, graduations–etc. You know that these events may be coming, but you don’t know when. Travel for these events can be expensive depending on when and where they are. And then there’s the cost of gifts. These would be appropriate expenses for the rainy day fund.

Let’s say you have children, and they are on school break. And, you literally have a rainy day–or worse, a string of rainy days. This is when you dip into the rainy day fund and plan an event. It could be a short trip, an educational experience, or just rain boots and raincoats so you can all go out and play in the rain.

Other examples of uses for rainy day funds would be medical co-pays or coinsurance payments and veterinary bills for regular checkups. You might also use the fund for the replacement or repair of small electronic devices, sports equipment, minor car repairs, and home maintenance expenses.

A rainy day fund differs from your emergency fund. Emergency funds are used to help cover large, unexpected expenses like major car repairs, major home repairs or large medical bills. The rainy day fund is used for smaller expenses that you know you are likely to incur, but you don’t know the timing, and you don’t know exactly how much they will be.

So, how much should you keep in your rainy day fund? As usual, with financial questions, it depends. If you have a large family, including your pets, then you’ll want to add more to your rainy day fund to help with those insurance co-pays and vet bills. If you and your household depend on electronic devices(don’t we all?), then you’ll want to add more to your rainy day fund as well. Take a look at what could happen in the next year to help you determine an amount. How old are your cell phones? How likely is it that you’ll need to replace them this year? How about iPads and other devices? What about small home appliances like coffee makers and toaster ovens/air fryers/etc., that you depend on? How much is the deductible on your car insurance? This is the amount that will come out of your pocket if there is an event involving your car. How about the kid’s activity levels? Will their activities likely lead to expenses like new sports equipment (or medical co-pays)?

The rainy day fund, like the emergency fund, helps with peace of mind. You can design your spending plan and account for all of the regular expenses.

However, everyone experiences unplanned–though

not necessarily unexpected–expenses from time to time. Your rainy day fund can help you cover those expenses without derailing the rest of your financial plan.

This article is intended to be educational and thought-provoking rather than financial advice. When we work together in a financial planning engagement, we discuss your unique personal situation and your unique goals. During our financial planning process, we examine these factors and many others to determine appropriate financial strategies for YOU.

BENEFITS TO HIGHER INTEREST RATES

By now, you’ve undoubtedly heard that “the Fed” has been raising interest rates to rein in inflation. Interest rates are an essential part of our economy, and their impact can be felt by nearly everyone who participates in financial activities. The federal reserve raises interest rates to restrict access to funds and hopefully slow down the rate of increase of prices, including wages, in the economy. While this sounds like an awful idea if you are a borrower or have used access to cheap money to grow your business, higher interest rates can positively affect savers and lenders. If you are a saver, higher interest rates mean you can earn more money on your savings. This can be really helpful if you are saving for a specific goal, such as buying a house, starting a business, or saving for retirement. With higher interest rates, your savings will grow at a faster rate, allowing you to reach your financial goals sooner. Another advantage of higher interest rates for savers is that they can help to combat inflation. Inflation is the rise in the cost of goods and services over time, and it can erode the value of your savings. In other words, if the prices of the goods you buy rise faster than the value of your savings, your savings can’t buy as many goods. However, if you are earning a higher interest rate on your savings, you can offset the effects of inflation and maintain the purchasing power of your money. For lenders, higher interest rates mean that they can earn more money on the loans they provide. This can be particularly beneficial for banks and other financial institutions that make a significant portion of their revenue from interest on loans. Higher interest rates can also encourage more lending, as lenders are more likely to provide loans when they can earn a higher return on their investment. And, when you purchase a bond, whether a government bond or corporate bond, you also become a lender and can benefit from higher interest rates. Retirees and others who live on fixed incomes are often savers and lenders—a large part of their income is often the interest generated from savings deposits and bond interest. After nearly a decade of extremely low interest rates, these new higher interest rates are a real boon to those living on fixed incomes. Another advantage of higher interest rates for lenders is that they can help to stabilize the economy. When interest rates are low, borrowing becomes cheaper, and consumers and businesses are more likely to take on debt. However, this can lead to an increase in inflation and a potential economic bubble, and in some cases, poor management decisions. Low interest rates can allow a company which is either poorly run or may not have an economically feasible business model to continue operations simply by borrowing cheap money. By raising interest rates, lenders can discourage excessive borrowing and prevent an economic crisis. Higher interest rates will have a different effect on savers and lenders versus borrowers. Savers can earn more money on their savings, combat inflation, and reach their financial goals faster. Lenders can earn more money on loans, stabilize the economy, and prevent potential economic crises. While borrowers may have to curtail spending in order to accommodate the higher cost associated with borrowing. While there may be some drawbacks to higher interest rates, the benefits for savers and lenders are significant.

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Myth: It’s always better to pay down debt as fast as possible

This post is part of our financial myths series

You may have heard that it’s always better to pay down debt as fast as possible. There are two huge flaws with this advice.

Here are some factors to consider.

What do interest rates look like?

What if you were able to take out a loan at 2.5%? And, what if at the same time you were able to generate 5% on your investment portfolio? Does it make sense for you to take funds that could be in your investment portfolio and earning 5% to pay off the loan at 2.5%? Possibly not.

Considering things like mortgage interest deductions and barring any additional costs of carrying the loan, you will come out financially ahead by taking your time to pay down that 2.5% loan.

Money is extremely personal

Money and finances are extremely personal matters. Your money story and your history with money is different than anybody else’s. For some people, having any kind of debt induces anxiety. It doesn’t matter if they could pay off their debt 10 times over and there is little or no chance of having their home foreclosed upon, their car repossessed or having levies on their income, they just don’t like having debt. In these cases, it really may be the best thing for these people to pay down their debt as fast as possible. It’s very hard to put a price on personal contentment-or determine the cost of personal anxiety.

Risk tolerance

For some folks, there is a great deal of uncertainty about their financial situation. For instance, their income might be very variable – changing from month to month and year to year. Those folks are already tolerating risk in their variable income. They may not want to take on the additional responsibility of those principal and interest payments. In those cases, it might be helpful to pay down debt when the cash is flowing. That can help reduce fixed payments and make life a little easier during those low-income periods of time.

The same thing goes for those who are getting ready for retirement. If cash and income needs during retirement will be met easily, then it may make more sense to look at this question with strictly black-and-white benefit and cost numbers. In other words, if the return on investments is significantly higher than the cost of interest on the loan, it may make sense to pay off the loan slowly. Use those funds to get the higher return on investment. Use part of that return to pay the interest, and you still come out ahead. On the other hand, if there is uncertainty about steady income during retirement, and especially if we are talking about the family home, you may want to have any indebtedness on the home paid off prior to retirement. Yes, there will still be ongoing expenses related to owning the home like upkeep and property taxes, but at least the monthly mortgage payments could be eliminated.

For the most part, we are talking about debt with fixed interest rates. There is additional risk if the interest rates are variable. Variable mortgage rates, credit card debt and lines of credit often come with variable interest rates. This means that while you may have felt that a monthly payment was reasonable when you took on the loan, and increased payment due to higher interest rates could be crippling. In those cases, the simple financial calculation showing costs and benefits needs to be balanced with the additional risk.

Using leverage

Remember, this is intended to be educational – not advice. In direct contrast to the notion that you should always pay down debt as quickly as possible, many successful investors actually take on debt just to build their investment portfolios. In other words, if they believe that they can get a better return on their investments than the cost of borrowing money to make those investments, they choose to incur the debt. They may do this even if they had cash readily available to make those investments. Because on the spreadsheet, with just black and white numbers, it shows a positive return. Again, this is just for educational purposes, not advice. These investors are taking on a serious amount of risk. They could lose their own money as well as borrowed money which they still have to pay back – with interest. But again, this strategy flies in the face of the notion that one should reduce their debt as quickly as possible.

I think the most important factor here is that money is very personal. Everyone handles money differently. Money affects different people differently psychologically. Some people get anxious having any kind of debt, while others look at it strictly as a tool to grow their wealth.

I think this is a prime example of making sure you are making informed decisions. Calculate the actual financial cost of carrying the debt versus any potential gain on the use of those funds. But ultimately, it comes down to how much risk you can tolerate and how comfortable you are holding that debt.