A while back, I posted about how to automate your finances. After you get your emergency fund set up, invest for retirement, and pay off any expenses (debt, rent, etc.), you’re ready to saving for discretionary expenses such as a vacation, a down-payment for a house, or college tuition for your son/daughter. Setting up multiple savings accounts will save you from frustrations when it comes time to determine whether you have enough money to spend on that dream vacation you want to take next year.
Savings Account or Investment Account
If you’ve been watching interest rates over the last 5 years, you’ll notice that they are extremely low. This may leave you wondering whether you should use a savings account or investment account for divvying up your savings. The answer comes down to your time horizon.
When It Makes Sense to Save in an Investment Account
Investment accounts are good for long-term investments that won’t be used for at least 5 years. This means your money will be locked up for a while unless you want to pay high commissions and short-term capital gains taxes. For example, opening a 529 investment account to save for college would make sense since most likely you won’t be paying tuition for many years. However, paying for your vacation next year is going to require readily available funds. In the financial world, the short-term availability of your funds is known as liquidity.
When It Makes Sense to Save in a Savings Account
When you need quick access to cash or, in other words, high liquidity. For emergency accounts, this is essential. You need your money fast without having to go into debt. Although the rate of return is lower for a savings account, you have the peace of mind that your cash will be there when you need it.
Compartmentalizing Your Savings
Now that you’ve decided what type of account you need, it’s time to start divvying your money up between accounts. The choice of what accounts you should have and how much goes into each account is up to you, but the principle for saving to these accounts is the same.
Automatic Transfers from Your Paycheck or Checking Account
The best way to save money in these accounts is to transfer money automatically. If your employer allows you to direct deposit to separate accounts, splitting up your paycheck before it even arrives in your checking account is the best way to automate your savings. This way you’re not tempted to spend this money frivolously. However, I currently have my direct deposit go straight into my checking account. I have automatic ACH transfers between my accounts to pull money from my checking account into my savings accounts. I only do this so that I earn reward points for transferring money between accounts.
Examples of Savings Accounts
What kinds of savings accounts should you have? Here are some examples:
Do you have enough cash to pay for a busted tire? How about for that broken windshield? By having a car savings account, you will have the funds to make these repairs. Got a speeding ticket? Pay for it from this account.
If you were smart and paid for your current car with cash, you could also start setting aside the amount that you save by not having a car payment into this account so that you have enough money to pay for your next car in cash.
Savings for a Down Payment
Most mortgage lenders look for a history (3 months) of having enough cash to pay for a down payment and a few months of mortgage payments. Start saving in a savings account for a down payment and when you have enough, transfer the sum to a checking account to furnish to the bank.
Savings for Vacation
Need funds to spend on your next vacation? Start saving for it in a savings account and soon enough you’ll have plenty to spend on nice hotels at a relaxing beach.
My Current Savings Accounts
Currently, I have 4 savings accounts that I feed regularly:
Wouldn’t a Lump Sum Compound Better?
If you know anything about compound interest, you know that the more money you have, the more it grows. Wouldn’t this logic apply to savings accounts as well? Shouldn’t you just put all your money into one savings account and divvy it up in your mind? The short answer is no.
It’s Too Easy to Overdraw an Account
Let’s say you have one savings account with: $5000 for a down payment and $1000 for holiday shopping. Now let’s say you go out on Black Friday and accidentally spend $1100. You just lost $100 from your down payment fund. By separating out these accounts, you won’t have the temptation to spend more than is in the designated account. Although you have the same amount of money, psychologically you’ll be restricted since the down payment is in a “Do Not Touch” fund.
The Interest Payments Aren’t That Much
As you can see below, the amount of interest you get from having separate accounts vs. one is the same, so you’re not losing any interest.
Open Some Savings Accounts to Join Capital One 360’s #Saving4 Campaign
Capital One 360 is currently offering prizes, including a $25,000 prize drawing, for opening new savings accounts through December 20, 2013 and tweeting at them. You can find complete instructions here.