These scenarios sound ridiculous, but we often do this with our money. We use the wrong tools for our needs. Here are some examples I have seen over the years.
- Retirement savings in a Certificate of Deposit (CD)
- Down payment for a house invested in stocks in a brokerage account
- Groceries paid for with credit cards
- Furniture purchased with a 401(k) loan
When defining our needs, we need to think about the right savings/investing tool while not getting caught up in the glamour of higher investment rates. We shouldn't be afraid of investing, either. Here are three guidelines for choosing the right vehicle to put money.
1. Short term goals need cash. Any item you need to pay for over the next year requires funds that are easy to access. In the examples above, groceries should always be paid for from current cash flow (your paycheck). Furniture can be paid for by setting aside money in a savings or money market account, then making your purchase. You should never have to pay interest on old stained sofas or asparagus from three months ago. This goes for emergency funds as well. The nature of an emergency dictates that you will need cash at a moment's notice for an unexpected event. Be sure you can access this money.
2. Medium term goals need liquidity, too. It may take you 5+ years to save enough for a home down payment and closing costs, so you might think about setting up an auto draft into a mutual fund so you can earn a return greater than a savings account. The fund you select should be one that is not excessively risky (ie: no Commodities or Hedge Funds). You don't want the market to take a dive as you could lose a substantial portion of the money you have saved. As the time approaches for purchase, about a year or so out as this becomes a short term need, dial down the risk and increase the liquidity. It's not uncommon for closing costs to change or for you to need extra funds, so move your money into a savings or money market account for easy access.
3. Long term goals can support greater risk. Unless you are very close to retiring, I can't think of a compelling reason to have retirement funds in a CD. Yes, markets are risky, but if you have the benefit of time on your side, you can invest on a regular basis and use the compounding effect of earnings on your investment to build a sizable nest egg. Don't use your retirement funds for anything else, either. No loans or college funding. Those items should be paid for through your diligent budgeting.
Matching your investment goal and timeline to an appropriate vehicle is key to keeping your budget and savings goals on point.