Savings and Budgeting
- Category: Finance
- Hits: 2,965
Savings for some future event, at its most basic level, is the disciplined act is putting money in some vehicle that will give a return on one’s investment. It can be as simple as a savings passbook account or CD, or as complex as bonds, notes and mortgages. The more complex the vehicle, the more the return and risk vary.
Savings and Budgeting
Individuals decide to save part of their income for some future needs. Those needs vary with individuals, levels of income, and types of plans. It could be for something as short-term as a vacation. It could be to help children with their education, wedding, or first home.
Or it could be as long-term as acquiring a second home. The ultimate for many individuals is savings as a cushion for retirement, even if contributions to an employer’s plan have already reduced net take home pay. The length of time involved to reach the goals means the techniques and financial instruments broaden from the simple to the more complex.
For an individual to save some of their cash inflow necessitates budgeting, a plan usually set down in writing, for a certain period of time. Typically it is usually for a short term like a month, but it could be for as long as a year. For example, the individual puts down on paper all the sources of their income – wages, interest, dividends, etc, net of taxes.
The next thing is to list current and usual expenditures, such as mortgage or rent, food, gas, insurance premiums, savings, entertainment and clothing allowances, charity, medical expenses, investments, utilities, and anything else the family regularly pays out. Then long-term outlays should be considered, whether they are planned for or meant to cover the unexpected. Putting aside money for this contingency should be included in any budget.
The plan should then be reviewed by members of the household to determine if some items need to be adjusted, reconsidered, or perhaps eliminated. Questions to ask would include alternatives, such as, “Will we need a new car in six months?” or “The refrigerator is 10 years old now. Will it last much longer or should we replace it now before it has to be repaired?” or “Do we really need to go on a big vacation this year or can we wait awhile?” The main consideration is, of course, if there is enough cash inflow to cover all that needs to be done.
Uhoh! John and Jane are facing a deficit this month.
Where do they cut?
What’s negotiable and what’s fixed?
Looking at expenses, it appears there are four areas that can be considered “negotiable” – their trip, medical, food, and savings. All other costs are fixed.
“Trip next year” looks like the best place to consider. Will they need $6,000 for that trip ($500 per month for 12 months)? Could they get by with a less expensive vacation, say $5,000 which would require about $420 per month? If not, could they put that trip off for awhile?
Having a budget that lays out income and expenses is a way to prevent unpleasant surprises down the line. One way to help prepare for short-term savings is a simple passbook account. This medium has advantages:
- easy to withdraw from;
- withdrawals are made without penalty;
- the individual is exposed to a very low level of risk.1 Its disadvantages are that the rate of return is generally low.
By the same token, its easy accessibility can make this account subject to over-use when handled without discipline. Other types of savings include “Christmas clubs” and checking accounts which pay interest on the balances.
Certificates of Deposit
A longer term investment would be an interest-bearing Certificate of Deposit (CD). This medium has a slightly higher rate of return than a savings passbook, is intended to be held until maturity, and is also low risk. The biggest disadvantage to a CD is that early withdrawal will result in a substantial penalty and tax consequence. Savings accounts and CDs actually represent a loan to the financial institution: funds are given to the bank or credit union to use for its lending activity but are in reality liabilities of the institution which must be repaid to the owner when called for.
The shorter time period to maturity of CDs means less risk but also lower return. After all, the funds an individual has put into these accounts are loans to the financial institution. The shorter the time that institutions have to use that money before returning it to depositors, the lower the interest rate they are willing to pay. By the same token, as maturity lengthens, the investor is at risk for loss of principal value. This issue applies only when the principal might exceed the FDIC limit of $250,000.
Money Market Accounts
Money market accounts, including some checking accounts, are mutual funds which pool the money of many individuals. These amounts are invested in very short-term obligations, such as treasury bills and notes, CDs, commercial paper, and other debt instruments.
Money market accounts are not protected by the FDIC and there is no restriction on the time or frequency when monies can be withdrawn. Individuals might choose to avoid the ease with which mutual funds can be withdrawn and invest directly in short-term obligations such as those listed above. However, while this direct investing may result in a higher return, it also entails a higher risk.
The further you get from the simple savings accounts and CDs, the more complicated the considerations become. For example, savings bonds are government issued and purchased at a discount. They can be redeemed early with penalty or held to maturity. The term for Double E bonds is currently between six and seven years but interest rates decline if they are held for longer periods. Double H bonds pay interest at regular intervals.
Investments in United States Government Treasury bills require large amounts of cash and have various maturities. They are purchased directly from a Federal Reserve Bank in $10,000 denominations and mature in ten years. Treasury notes, on the other hand, have face values between $1,000 and $10,000, are purchased at a discount like Double E bonds, and mature in one to ten years. The interest on direct obligations government bonds is exempt from state income tax. However, bonds from government agencies such as Fanny Mae are subject to that tax consequence unless purchased before December 31, 1987.
Some select municipal bonds, also called munis, are exempt from both federal and state income taxes while some are only exempt from state taxation. A tax professional is the best source of information on this issue for an investor’s state.
Ultimately there is a cost for saving a portion of your income, known as the “opportunity cost.” When funds are invested in an obligation which has a specific maturity date before it can be redeemed without economic consequences, the investor sacrifices his or her liquidity: if the speedboat one has always wanted suddenly comes up for sale and that person doesn’t have ready cash with which to take advantage of the deal, you may lose out. It should be obvious that savings and investing involve both negatives and positives.
In considering one’s regular net income, some individuals over-withhold on their income taxes as a form of forced savings to receive a larger income tax refund next year. The person is actually lending money to the government but not receiving any interest on it. It would definitely be to one’s advantage to put the difference in withholding tax into a vehicle that would give the individual more of a return than the government does, which amounts to zero.
Putting savings into conventional financial institutions such as banks and credit unions is a safe and simple way to invest. But as you mature in your economic understanding you should consider alternatives, expanding to more complex transactions, such as “Zero Coupon” bonds. These pay no periodic cash interest and are issued at a deep discount; the investor receives the interest at maturity. The return is usually greater but these bonds are dangerous and extremely risky. Also the investor generally pays income tax on that interest before actually receiving the proceeds.
Another alternative is borrowing money to fund large purchases, whether for one’s own use or to obtain a rental property. This sounds counter intuitive but it can be to the investor’s advantage. The buyer puts up a cash down payment and borrows the remainder. However this type of transaction involves the consideration of several factors, including one’s ability to meet the commitment incurred in borrowing.
The current mortgage rate is very low, in many cases below 4%, and the interest is deductible on an income tax return. When the property purchased is for rental, all expenses incurred for the upkeep and maintenance of the unit are deductible and the property is subject to depreciation.
A mortgage analysis is not simple and can involve uncertain future conditions in the economy. I am often asked by clients whether they should pay off or refinance their home mortgages. My answer is that it depends on how much principle is left to pay, what their current interest rate is, how long a term they are locked into, and other considerations.
There is a way for seniors to turn home equity into a ready cash source when other alternatives are not available: The reverse mortgage may have some merit in certain cases. An individual at least 62 years of age in need of fast cash with no other options available would receive funds using their home equity as collateral.
A lending institution would give you cash based on the following:
- age of the homeowners,
- current interest rates,
- the fair market value (FMV) of the home,
- government limits on the amount that would be available.
The debt would not be repaid until the last homeowner leaves or dies and the estate then takes on the liability. If the home is sold for less than the balance, the estate would only pay the difference. There are pros and cons on a reverse mortgage, the most obvious benefit being that it may be the only way to obtain cash without incurring any tax consequences.
The biggest disadvantages are:
- it requires the owners to remain in the home for an extended period of time,
- the estate is deprived of a valuable asset,
- a reverse mortgage must be a first mortgage, not a home equity loan, and
- some costs, such as points at closing, are charged at 2% of the home’s property value.
A reverse mortgage is a good alternative if the homeowners cannot meet their current obligations, or if the property is in danger of foreclosure.