Saturday, December 4, 2010

Saving for a Rainy Day - How much?

They say you should have enough saved to live on, for 6 months to a year or more - and that doesn't count your 401(k) or IRA money!  How much do you need to save to be secure?

To build wealth, you have to accumulate money over time.  This means spending less than you earn.  The less you spend and the more you earn, the faster you accumulate wealth.  If you spend more than you earn, you don’t accumulate wealth, you dissipate it.

And since you are borrowing money to spend more than you earn, the process is compounded, as you pay interest on these loans, which means you are spending even more - which in turn means you dissipate wealth faster and faster.  Getting off the debt bandwagon - a popular bandwagon - and living on a cash-only basis is essential if you are going to accumulate wealth.  And by cash basis, I don’t mean paying cash for everything, only that you should not spend money that you do not have (borrowing on credit cards, car loans, etc.).

But if you are going to live on a cash basis, you have to have a cushion of money in after-tax savings that you can get at, if your income flow is interrupted for any reason.  How much money should you have laying around as a reserve?  Many economic advisers recommend having enough money in savings to live for six months to a year, so that if something bad happens (disabled in a car accident, for example) you can coast on your savings, at least for a while.

And of course, most Americans, living paycheck-to-paycheck, have little or no savings to coast on - only credit cards, and those are maxed out.  So if bad things happen, they go further and further in debt, and end up broke and destitute.

And the problem with living the debt lifestyle is that what you need to live for six months can be a staggering amount of money.  Until I became debt-free, I would have required at least $3500 a month to service all of my debts, perhaps more.  And for many Americans, this is the case - even if they have no credit card debt.  Most Americans have onerous mortgage payments that amount to 1/3 of their gross income.  And on top of that, they stack lease payments or loan payments for cars ($500 to $1000 a month in some instances!) and then add a host of subscription services, for everything from Cable TV to text messaging plans.  Their monthly cash-flow requirements are staggering.

For most Americans, therefore, it is hard, if not impossible to accumulate savings to live for six months to a year, as that amount of money would be huge - probably more than they have in their 401(k).  And if they had that kind of money in savings, they wouldn’t be paying monthly payments on car loans and credit cards, would they?

However, one way around this is very simple.  If you are debt-free, the amount of money you need to live for six months to a year will drop significantly - by more than half, in most cases.  So one way to boost your relative savings is to decrease you monthly expenses.  Get out of debt and stay out of debt, and suddenly, a year’s expenses is not a lot of money.

When we were in debt, if I wanted to have enough in savings to “coast” for a year, I would have needed, easily, $50,000 to $70,000, just to cover my debt obligations, property taxes, utilities, and food expenses.  And not surprisingly, I didn’t have that kind of money laying around - most of my free cash went to servicing debt or into the 401(k) plan, to try to reduce my taxes (having to earn more to pay off debt, my taxes went up, so I had to put more in the 401(k) to reduce my tax rate - chasing the tax code is a vicious circle!).

But now that I am debt-free, what do I need to live on per year?  $12,000 a year will cover our food, drink, and entertainment, easily, according to past consumption levels (and this could be cut dramatically, if necessary).   Insurance, utilities and property taxes on the house and cars might run another $12,000 a year, if that.

Suddenly, I only “need” $25,000 a year to live on.  So $25,000 in the bank, which might have supported me under the debt lifestyle for only six months, is enough to live on for a year or more.

And whoa, it means now that I can retire on hardly any income at all - what we would get from Social Security, if necessary.

And all of that, just by being debt-free.