After you’ve mastered the basics of budgeting, and you’ve gotten rid of any high interest debt, having just a little extra each month should become normal. This “extra” is the money you’ll use each month to save and invest. But before you make a decision about how to use this money, you need to know the difference between saving and investing.
Saving vs. Investing
Though “saving” and “investing” may be used interchangeably, saving and investing are very different activities with different goals:
The act of setting aside money for a particular purpose, such as the purchase of a car or home, or to create the ever increasingly important emergency fund.
The act of buying specific investment products, such as stocks, bonds, ETFs, CDs, real estate, or mutual funds, with the long-term goal of increasing the value of your principal (the original amount of money you invested). Investing can also be geared toward specific purposes, such as retirement or college tuition, but the goals for which people invest tend to be far off in the future.
Risk in Saving and Investing
Saving and investing also differ in terms of risk — the chance that your principal might lose value. Since the money you put into savings is meant to be used for a particular purpose in the near future, you cannot put that money at risk. Typically savings is deposited into a federally insured savings account, though there are some other alternatives (I’ll discuss alternatives to savings accounts next week).
Money that you invest, on the other hand, can tolerate some risk since it most likely won’t be used for a number of years. But that doesn’t mean you should proceed cautiously …
Should You Save First or Invest First?
Once you have a regular monthly surplus of at least 10% of your pretax income, you’re ready to save and then invest. Generally it’s best to do so in the following order:
Save up an emergency fund
An emergency fund is an amount of cash you keep in a savings account for use in emergency situations, such as a layoff, a prolonged illness, or a death in the family. An emergency fund gives you peace of mind and prevents you from falling into debt when unexpected expenses arise. Most financial advisors suggest that an emergency fund contain six months’ worth of living expenses. Personally, I would plan to deposit this money into a traditional, FDIC-insured savings account such as ING.
Save for specific savings goals
A savings goal is the total amount of money that you need to save up in order to be able to afford a specific purchase. For instance, if you’d like to buy a $5,000 engagement ring, your savings goal is $5,000. You might consider saving money for Christmas expenses, or a family vacation. Your first savings goals should be for essentials, such as a car or furniture. Next, you may want to save for more major goals, such as a down payment on your own home.
Investing is usually the most effective way to build wealth over time. Until you’ve achieved all of your saving goals, typically the only kind of investing you should be doing is investing for retirement through an IRA or a work-sponsored plan, such as a 401(k). Once you’ve achieved your main savings goals, you can start investing your entire monthly surplus, or just a portion of it. Talk about putting your retirement portfolio in steroids!
Savings Account Options
Here are a couple of online options for setting up your savings account.
The Orange Savings Account from ING (My personal favorite) Featuring – no fees, no minimums and no need to change banks! FDIC Insured.
EverBank offers high yields, online access, and FDIC insurance on your deposits (now up to $250,000).
HSBC Direct Online Savings offers competitive yields, no monthly fees, no minimum balance required, FDIC-insured to the maximum allowed by law, and allows you to transfer funds online to and from your other bank accounts.
Additionally, check out my online banks page!