Most people’s personal finances don’t measure up to the typical advice from experts. This is particularly true for young people who haven’t had a chance to build up retirement savings or an emergency fund. Knowing that your finances need improvement can make you feel guilty and worried every time you spend some money. The remedy for this is some planning and setting yourself on the right path.
I think of my savings as three categories: long-term savings, medium-term savings, and an emergency fund. Each serves a different purpose in keeping your finances on track.
Most experts call this “retirement savings,” but I prefer “long-term savings” for a couple of reasons. For one, it can be difficult to motivate people to save for their much older selves. Another reason is that you may end up using the money for some other purpose. You shouldn’t use it for consumer purchases like cars, but you may use some of it to fund a career change or a move to another country. Building a pot of money gives you choices during your working years and funds your lifestyle after you retire.
Each person should decide how much to save for the long term. My default recommendation for young people is 20% of take-home pay. But individual circumstances can make higher or lower percentages make sense. It’s reasonable to count company-sponsored pension plans toward this percentage.
Medium-term savings are for covering any large purchase you can anticipate that is outside your usual monthly spending. Suppose you want $15,000 to buy a car in 5 years and you get paid every 2 weeks. You have 130 pays to save up and should add $115 per pay to your medium-term savings. If you want to take a $4000 vacation in two years, that’s another $77 per pay to save. If you’re planning to get married in 3 years and have to pay $10,000 of it yourself, you need to save another $128 per pay.
It can be scary to add up all the things you hope to spend money on: what if it’s all too much? Go ahead and add it all up anyway. Maybe you’ll get lucky and the total savings per pay will be manageable. If not, you’ll have to scale some plans back. Whatever happens, it’s better to figure it all out now as best you can instead of never being sure whether you can have the things you want in the future.
No financial plan can anticipate everything. That’s where an emergency fund covers you. Maybe you’ll lose your job and it will take a while to find a new one. Maybe the cat will need an operation. Going further into debt each time life knocks you down is a formula for financial disaster.
Experts usually recommend that your emergency fund be enough to cover essential expenses for 3 to 6 months. Figure out how much you could cut back if you were out of work and add up the essential expenses such as rent, food, and clothing. This will give you a target amount to save.
The next thing to decide is how much you’ll save from each pay toward your emergency fund. Even as little as $50 every two weeks will give you $10,000 in less than 8 years. Once the emergency fund is full, you can add that $50 to your day-to-day spending. But, if you’re ever forced to dip into your emergency fund, the $50 per pay savings has to start up again.
When you don’t have enough long-term and medium-term savings or your emergency fund isn’t full, you need to cut back a little from day-to-day spending to carve out some of your pay for saving. However, having high-interest debt such as a credit card balance is a more serious situation. You may have to put off other saving to focus on killing off the expensive debt as quickly as possible.
Some lifestyle changes to reduce spending should be automatic if you owe on credit cards. Eliminate non-essentials like eating out and other indulgences. This can be difficult, but the pain should only be for a short time. Once the credit cards are paid off, the large payments you made can be split between various categories of saving and increased day-to-day spending.
Automate the Savings
A key to making a plan like this work is to automate the saving. When your pay lands in your bank account, the amounts you’ve decided should go into savings should be set up to go automatically. It’s far too easy to skip the saving one pay or stop altogether.
Benefits of this Plan
Once you’ve made a plan and you know that while your finances aren’t perfect right now, they are on the right track. The direct benefit of having a plan and following through is that you’ll have solid personal finances. But there is an indirect benefit. After your automated saving amount and your fixed expenses come off your pay, whatever is left over you can spend in any way you see fit, guilt-free.