Saving money is like having insurance. You don't realize it's important until you need it. The first type of savings plan that comes to mind is making a regular deposit to your savings account. Many people have found it much easier to save by payroll deduction—having the employer deduct a fixed amount from the paycheck each pay period and applying it to a designated savings vehicle. This method gets the money out of your hands before you spend it. If your employer doesn't have a payroll deduction plan, many banks will draft your checking account each month and deposit it in a savings account. But if you want to write a check to deposit in your savings account, make sure it is the first check you write when you sit down to pay your bills. The savings habit is its own reward.

 

A Cash Reserve

            Saving money consistently will prepare you for investing. A cash reserve is the foundation of any financial plan (see fig. 7). The main benefit of your cash reserve is that you earn a safe and guaranteed return and the funds can be converted to cash without a penalty or loss of principal. Your total cash reserve should be equal to at least six months' expenses. If your monthly expenses total $1,000, your cash reserve should amount to at least $6,000.

            Why do you need a cash reserve? It gives you an immediate supply of hard cash to cover monthly expenses in the event of an emergency. The money to build your cash reserve will come from your regular savings plan. That's the 5 or 10 percent of your monthly net income you promised to set aside on a regular basis. A cash reserve will protect you from financial hardship.

 

Types of Savings Accounts

            What type of savings account is best for you? Consult a knowledgeable bank representative or financial consultant. By outlining your investment objectives and seeking advice, you can more clearly see your alternatives, and you can make choices. Your investment objectives for your six-month cash reserve must be safe and easily converted to cash. For starters, you will need a money market account, which will allow you to make deposits and withdrawals without a penalty. Keep the equivalent of three months' expenses in this account.

            A certificate of deposit, commonly called a CD, is a redeemable bond issued by a bank with a maturity of from ninety days to five years. If the interest rate is high, you can keep an amount equal to three months' expenses in this type of account with a maturity of not more than three months.

            So you will have a total of six months’ expenses all in one money market account or divided equally between a money market account or CD. A savings account and a CD are important tools for building your cash reserve fund.

 

Compound Versus Simple Interest

            Benjamin Franklin wrote, "Money can earn money, and its offspring can earn more." Once you start comparing savings accounts, you'll discover that the interest rate can be calculated several ways. The interest rate you receive on your money is as significant as how often the interest is compounded.

            Compound interest is the method by which your interest earns interest. Simple interest means you don't receive interest on your interest; you earn interest only on the principal, the original amount you deposited.

            For example, $1,000 compounded monthly at 9 percent will grow to $1,309 in three years. The same amount at 9 percent simple interest will grow to only $1,270, a difference of almost $40. The advantage of compound interest is even more evident with larger amounts. It is equally important for you to know how often your interest is being compounded—yearly, quarterly, monthly, or daily. Don't be afraid to ask questions about your money. Learn all the details.