Managing Your Short-Term Money
It's easy to find books and articles on how to manage your money to support your long-term goals. You can read a lot about stocks and bonds, retirement accounts, investing in gold, real estate, options and futures. But managing your day-to-day spending money tends to get short shrift. Here's a primer.
There are three big reasons to hold cash: Liquidity, short-term goals, and emergencies.
You need a certain amount of money on hand just to pay your bills. People whose bills are small and predictable can actually get by with very small liquidity balances--a student living in a dorm with a meal plan, for example, might only need to carry a liquidity balance big enough to keep him in sodas and pizza.
If you've got a handle on your expenses, it's very easy to figure out what you need for a liquidity balance: It's the total of all the money you need to spend between now and the next time you'll get some income.
Most people's expenses vary from month to month--you need less in spring and fall when you're not running the heat or the air conditioner, but you need more for the months the property taxes and insurance payments are due. You can, if you want, adjust your liquidity balances to match.
My wife and I actually do that. Each month we know pretty accurately what our bills are going to come to: We know which months things like insurance bills need to be paid and we keep track of how much we've charged on our credit cards. Pretty much everything else except the electric bill is the same every month. Each month we figure out what we're going to have to pay out and make sure there's enough in the checking account to cover it.
Most people don't bother--they just carry a liquidity balance that's big enough to handle their expenses in any ordinary month. Especially when interest rates are low, there's no problem with this. (When you can earn a significant return on your savings, there's a real cost to having money sit idle in your checking account. Right now, not so much.)
While your budget should cover all your regular expenses--including things like tax and insurance bills that come just once or twice a year--there are things that you'll want to spend money on that aren't so regular. Still, except for emergences, most of the other things that you'll need cash for are nevertheless broadly predictable. You should have a plan for them, whether you structure it as part of your budget, or just as a list of stuff you want.
A homeowner knows to expect (and gradually set aside money for) a new roof, furnace, air conditioner, appliances, carpets, repainting, and so on. Even though many of these expenses won't be incurred for ten or fifteen years, they're still expected. A car owner can include routine maintenance in the regular budget, but knows that an old car may need major repairs--and will in any case eventually need to be replaced. More broadly, everyone has things that they want--a vacation, a motorcycle, a musical instrument, a really good camera, a boat, the complete works of L.L. Zamenhof--that they're intending to get in the next few years.
A few of these things may be medium- or even long- term goals--if you're not planning on buying them anytime soon. Roughly speaking, I'd call anything that you don't expect to spend any money on for 5 years a medium-term goal, and anything that you don't expect to spend any money on for 10 or more years a long-term goal.
Money to support your medium- and long- term goals can be invested for the long term--in fact, much like you invest for other long-term goals, such as retirement. For short-term goals, though, you should mostly stick to cash.
Your liquidity balances cover your expected cash needs from paycheck to paycheck. Your emergency fund covers any unexpected cash needs--either unusual expenses (the water heater goes out and needs to be replaced) or a drop in income (your employer cuts your hours or lays you off).
The usual rule of thumb is that you should have 3 to 6 months expenses in your emergency fund. (For an analysis of why and a look at some special cases, see my post Figuring the size of your emergency fund.)
How to do it?
First, figure out how large your liquidity balance needs to be, and get that much money into your checking account. Then, each time you get paid, put enough money in the checking account to cover your budgeted expenses. If you find it more convenient to keep a larger liquidity balance, you can just put in an average amount each month (and then adjust once or twice a year). Or, if you prefer, you can figure out exactly how much your bills are going to be and pay in exactly that amount. Either way works fine.
Second, top up your emergency fund. If your emergency fund is smaller than it ought to be--either because you had an emergency and spent some of it, or because it's never been as large as it should be--pay any surplus money you have after paying your bills into the emergency fund.
Third, direct any remaining cash into whatever account you use to save for your short-term goals.
That's really all there is to it. You can fund your longer-term goals at any point along the way:
- Before (through payroll deduction into your 401(k), for example),
- During (such as by sending money to a mutual fund at the same time you pay your bills),
- After (by accumulating savings until there's enough to buy 100 share of some stock you like).
Pick any combination of those methods that seems like it'd work for you. (Just don't pick none of them.)
Where to keep your cash
There's no need to get fancy about your short-term money. All you really need is a transaction account of some sort for paying your bills. If it pays a good rate (and you're the sort of person who can keep track and not spend money just because it's there), you could even keep your emergency fund and your short-terms savings there as well.
Most people prefer to have separate savings accounts for their emergency fund and the savings that they're accumulating for specific goals. A savings account at your local bank is fine. An internet savings account may pay a better rate. A money market fund is also a good choice.
To the extent that you know that you're not going to use the money for a period of time (college savings, for example) you can put the money into CDs or short-term bonds with a maturity date that matches when you're going to need the money.
It may be worth it to allow a bit more complexity to creep in. For example, I keep half my emergency fund in my local bank and the other half in the form of two 6-month treasury bills with maturity dates 3 months apart. As long as I have no emergencies (or only small emergencies), I roll over each treasury bill as it matures. If there's an emergency, all I have to do is nothing and each maturing bill will pay a quarter of my emergency fund directly into my checking account. (At the moment I'd probably earn a better rate with that money in CDs at my local bank, but the setup has been so convenient, I've left it alone for now.)
I also recommend that you keep some amount of cash on hand in the form of actual banknotes, even if you usually use credit or debit cards even for small purchases. There are some problems where the best solution is real cash money. Especially with interest rates as low as they are right now, there's no reason not to have some on hand. Think of it as part liquidity balance, part emergency fund.
It's still all your money
There are lots of reasons to divide your money up into multiple accounts--the retirement accounts have tax advantages, the mutual fund accounts give you access to specific investments, this or that bank's savings account pays a higher rate, and so on. The fact remains, though, that it's all your money: your entire portfolio is a single unified pool of assets that supports all of your goals--retirement, buying a boat, paying tuition, your summer vacation, etc.
Some people like to have a bunch of sub-accounts where they accumulate money toward specific short-term goals. I understand the inclination, but I suggest that you don't do this. Instead, choose where to save and invest based on the planned timeframe of the purchase. Your long-term goals should be supported by long-term investments like stocks and bonds, your medium-term goals with things like intermediate-term bonds, and your short-term goals with savings or short-term CDs. You really only need one savings account to save up the money for all the things you want to buy in the next year or two.
It's worth thinking about it correctly right from the start for this reason: While it doesn't make much difference when you're dealing with short-term cash, understanding this is critical for managing your long-term investments, especially the ones in retirement accounts, which is the topic of my next post: Optimize your 401(k).