Building Your Financial House - Tips to Build Your Emergency Fund Faster - Compound Interest

Building Your Financial House - Tips to Build Your Emergency Fund Faster - Compound Interest

While there is little doubt that things are bad right now in the Economic picture, speculation abounds as to when recovery will occur. Some learned voices are calling for a recovery as early as next spring, while others are looking at a 14 month recovery. Either way, it looks to be gloomy for the near future.

Unemployment is rising here in the US; the number most often quoted regarding unemployment is the number of new filers, not the current number of people receiving unemployment benefits. Even scarier, the reported numbers do not include the number of people who have used up their seven weeks of unemployment insurance, but are still unemployed.

This makes the topic of an Emergency Fund even more critical, although for some people it is a little late to be getting around to this activity now. For those of us with an income, there is no better time (except for the past) to start building your Emergency Fund.

Previously, I identified the amount of time to totally fund a reasonable Emergency Fund as being 5 years. This took the following factors into consideration:

Saving 10% of all Income into the Emergency Fund
Saving a total of 6 months of Income

To cut down the length of time it will take to build your Emergency Fund to completion, you need to think about a couple of tactics, namely getting your savings to work for you, tapping resources you may have overlooked and creative budgeting. BEFORE you begin these strategies, you need to have established the behavior of Saving 10% of all Income and paying your bills on time. If you have not mastered these skills, you can seriously jeopardize your existing Emergency Fund.

Getting your savings to work for you - this is a wealth building skill that you will use throughout the Building of your Financial House, so using it to build your Emergency Fund is a good way to learn. As you are Saving 10% of all Income, that money is sitting in a Savings Account. Each month the institution holding your account pays you a nominal interest payment, adding it to your existing balance. Each month, that little bit gets added and becomes part of the principal that earns interest as well. This is called Compounding Interest and is truly a concept that you need to master. The other interest option is called Straight Interest and you don’t want that kind of interest for your savings. Here’s why:

Straight Interest example - 3% Annual interest bearing account
Account Balance as of 1/1/00 $1,000.00
Interest paid on 12/31/00 $30.00
Account Total $1,030.00

So your account grew $30.00 in a whole year. The next year would look like this:

Straight Interest example - 3% Annual interest bearing account
Account Balance as of 1/1/01 $1,030.00
Interest paid on 12/31/01 $30.90
Account Total $1,060.90

Not real exciting.

Compound Interest example - 3% Annual Interest bearing account, compounded monthly
Account Balance as of 1/1/000 $1,000.00
Interest paid on 1/31/00 $2.55
Account Balance $1,002.55
Interest paid on 2/28/00 $2.31
Account Balance $1,004.86
Interest paid on 3/31/00 $2.56
Account Balance $1,007.42
Interest paid on 4/30/00 $2.48
Account Balance $1,009.90
Interest paid on 5/31/00 $2.57
Account Balance $1,012.47
Interest paid on 6/30/00 $2.50
Account Balance $1,014.97
Interest paid on 7/31/00 $2.59
Account Balance $1,017.56
Interest paid on 8/31/00 $2.59
Account Balance $1,020.15
Interest paid on 9/30/00 $2.52
Account Balance $1,022.67
Interest paid on 10/31/00 $2.61
Account Balance $1,025.28
Interest paid on 11/30/00 $2.53
Account Balance $1,027.81
Interest paid on 12/31/00 $2.62
Account Balance $1,030.43

Again, not real exciting, but you were paid $0.43 more than with straight interest and that’s the point. Your money worked just a little bit more, it put a little bit more in your pocket. Multiply that by 10 and you would be getting an extra $4.30; by 100 and you are getting an extra $43.00.

Nobody is going to get rich from this little bit extra a year, right? Well, yes, they do. If the Account balance was $1,000,000.00 at the beginning of the year, the extra little bit was $430.00. The total interest paid was $30,430.00. If there was no other income at all for this single individual (the $1,000,000.00 is not taxed because that tax on it was paid in prior years) the income tax due according to 2007 rates would be $2,860.00. The income tax due on Straight Interest income ($30,000.00) would be $2,793.00. Sure, there was an additional $67.00 in taxes due, but the difference in money kept is $363.00.

So, over 10 years the additional money every year (not reinvested )amounts to $3,630.00. Are you seeing the key yet? Time. Compound Interest over time produces significantly more wealth than Straight Interest or no Interest.

There are a lot of Interest Calculators on line that will figure out for you for much return you get at what rate invested for how long. You can also set up an Excel or Quattro Pro spreadsheet to do the same thing for you.

So how does this work for you right now to help build your Emergency Fund? Well, it works slowly, but surely. You need to structure your Emergency Fund so that some of your money is available in case you need it right now and some of it works a little bit harder. Here is a reasonable structure for your Emergency Fund:

1 Month’s worth of Income in your Savings Account (interest rate will be about 0.05% - this is really low)
1Month’s worth of Income in a 3 Month CD (Certificate of Deposit - rates run good and bad, currently about 2.45% - not great, but better than your Savings Account) that matures on a Jan/April/July/October cycle.
1 Month’s worth of Income in a 3 Month CD that matures on a Feb/May/Aug/Nov cycle.
1 Month’s worth of Income in a 3 Month CD that matures on a Mar/Jun/Sep/Dec cycle.
1 Month’s worth of Income in a 6 Month CD that matures on a Jan/July cycle (today’s rates are looking like 2.90%)
1 Month’s worth on Income in a 6Month CD that matures on a April/October cycle.

Certificates of Deposit are insured by the Federal Depository Insurance Company (FDIC) at most financial institutions - you want to make sure that your CD is will be insured prior to purchase. The minimum purchase for most CD’s is $1,000.00; some CD’s start at $5,000.00 or more - they often have better interest rates, but are for longer terms as well.

With this structure for your Emergency Fund, you have access to a month’s worth of income at all times. If you don’t need the money, you renew the CD for another 3 Month term. If you do need it, you put it into your savings account and draw against as needed. If you do use it, as you rebuild your savings account back up, open another CD when you have the excess funds in your Savings account again.

If you have learned to Save 10% of all Income and pay all bills on time, you can start building your structure as soon as you have $1,000.00 more than one pay period income in your Savings account. If you are going to do so, open the first CD with just $1,000.00 and only for a 1 Month term. Keep renewing the 1 Month CD and putting the interest in your Savings account. Keep adding the 10% savings to your Savings account. Now you have three income streams into your Savings - your 10% Savings from Income, the Interest from the Savings Account itself and the Interest from the CD. It’s little, but it all adds up faster than just 10% alone. As soon as you have another $1,000.00 open the 2nd CD for a 3 Month term. Keep the 1st CD at 1 month and keep renewing both of them. As soon as you have another $1,000.00 in Savings, open the 3rd CD for a 3 Month Term and renew the 1st CD in the proper 3 Month Term cycle.
Now build another $1,000.00 in Savings and add it to one of the CD’s at renewal. Build all three CDs up to $2,000.00. Keep doing this, renewing the CDs and building them until each of them holds a full month’s Income. Remember to include your interest income in your Monthly Income total - it is now part of your Income.

Once you have the first 3 CD’s set up, set up one of the 6 Month CDs with $1,000.00, Then set up the 2nd 6 Month CD. Increase both of these to the proper amount.

Finally, bring your Savings all the way up to a full Month’s Income.

By structuring and building in this manner, you have maximized the earning potential of your money instead of letting it all sit at a really low interest rate. This planning and looking for better ways to make interest on your cash holdings, but minimizing the risk is one of the most basic and safest way to increase your wealth and Build your Financial House.

This skill alone will decrease the amount of time necessary to build your Emergency Fund, but not by a whole lot. The next step is to find resources you may have overlooked and this is the topic of the next article.