Building a strong financial foundation is a step-by-step process: (1) establish an emergency fund totaling one month's worth of essential living expenses, (2) get out of debt — at least all debt other than a reasonable mortgage, (3) build a bigger emergency fund, (4) then start investing. If you skip over the savings step in pursuit of better returns by investing, you risk having to take money out of a temporarily depressed investment account during a market downturn to cover an emergency.
Expect the unexpected
In life, surprises happen. Home or car repairs may be much more expensive than the amount you have budgeted. Medical bills can far exceed what your insurance will cover. Or, you could experience one of the worst possible financial emergencies — unemployment for an extended period of time. You simply need to have some money in reserve to protect against such possibilities.
Thankfully, there's a spoonful of sugar to help the savings medicine go down. Having money in reserve is good for your health and your relationships. People with a savings cushion tend to experience less stress than those without savings. Married couples with a solid base of savings tend to have fewer financial disagreements than those without such resources.
A national survey conducted by the market research firm Synovate found that people with at least six months' worth of living expenses in savings were 60% less likely to report feeling stressed about their finances than those with no emergency fund. By the same token, research conducted by Professor Jeffrey Dew at Utah State University found that marital conflict tends to decrease as household assets, such as savings, increase.
How to, and how much?
Savings-account money should be safe and easily accessible so you can make withdrawals whenever a need arises. The bank or credit union where you have a checking account may be the most convenient place to maintain a savings account. If you're intent on earning more interest, an online bank could be a good alternative.
(An investment account, by contrast, is for money that you won't need for at least five years, which should provide enough time to ride out the market's ups and downs.)
Once you're out of debt, build an emergency fund that could cover three to six months' worth of essential living expenses. Which end of the range is right for you? It depends, in part, on how many breakable moving parts you have in your life. Home-owners need more in reserve than renters. People with health issues may need to have more set aside than others, depending on their insurance coverage. Those with less stable job or income situations should probably have more in savings than those whose incomes are relatively more secure. Single-earner households probably need more savings than dual-earner households.
A second savings account
In addition to a dedicated savings account for emergencies, we recommend maintaining a second savings account where you set money aside for irregular bills or expenses — those that occur sometime each year, but not each month. Examples include semi-annual or annual insurance premiums, property taxes (if paid separately from your mortgage), an annual vacation, and Christmas gifts.
Set up an automatic monthly transfer from checking to this savings account in the amount of one-twelfth of the annual cost of all such bills and expenses. When the bills come due, you'll be glad to have the money set aside. You also may want to have separate "accumulation" savings accounts for things like saving for a replacement automobile or other big-ticket, long-term items.
One savings loophole
The only exception to the "save before investing" rule is when you're eligible to participate in a 401(k) plan that offers an employer match. If your employer will match your contributions — many will do so at 50 cents per dollar you contribute or even dollar for dollar, usually up to 3%-6% of your salary — that's such a great deal, we'd hesitate to pass it up. So, if you can still build savings while also contributing to your workplace plan to get the match, we'd suggest doing that.
Building savings will never score very high on the thrill-o-meter of life. However, having a well-stocked emergency fund will contribute mightily to your peace of mind as you pursue your investment goals. So, build savings first, then invest.