I sometimes phrase it like this: use the stoplight rule.
- Less than 3 months expenses in the savings fund? Red light. Defer all discretionary expenditures.
- 3-6 months expenses in the savings fund? Yellow light. Some discretionary expenditures allowed, so long as you don’t dip back into the red light zone.
- More than 6 months expenses in the savings fund? Green light. Discretionary expenditures allowed, so long as you don’t dip back into the red light zone.
But let’s take another look at the buffer, and why you might like to have it bigger. Consumer finance charges really eat into the incomes of many people. What if your buffer was so big that you could:
- Pay your insurance premiums in annual installments?
- Buy your next car without financing it?
- Pay off your credit card bills in full each month?
- Ask for a discount for cash when buying big ticket items? (You’d be surprised. I drove quite a deal with my orthodontist for my wife and eight kids. I’m the only one that hasn’t had braces.)
- End the escrow account on your mortgage?
- Pay tuition bills in full, rather than a payment plan?
- Take advantage of financial crises, and extend credit at tough times? (I am still receiving 13% from a business associate that I lent money to in March of 2009, with warrants.)
- Retain cash in your corporation to reduce financing costs?
- Not worry about the minor disaster that recently hit?
- Raise your deductibles on your Auto, Home and Health insurance premiums to save money?
- Receive discounts on services that you want to receive, by getting a discount for buying years ahead?
- Fund your 401(k), IRA, HSA, whatever, to the fullest?
- And more…
So, even though you can’t earn anything by saving, there is still the advantage of receiving a discount for full cash payment up front. That doesn’t change, and because there are so many with bad finances, that discount is still valuable to businessmen who don’t want to deal with the costs of bad credit.
Now be wise. When you use your liquidity to buy ahead, plan to replenish the buffer. Don’t do everything at once; note the limitations of your liquidity, and act accordingly.
This is basic stuff, but I see many neglecting it. Incidentally, the same rules apply to small businesses. Being well-capitalized has advantages. Take advantage of vendor finance discounts where you can.
Seek discounts for prompt cash payment wherever it makes sense.
I’m not saying be a miser and hoard cash. I am saying there is a happy middle ground where you have enough cash to meet most contingencies and normal needs, and use the remainder to further long term goals and whatever you enjoy.
PS – I write this by the light of four candles as I continues to wait for power to be restored. The candles illuminate my keyboard. I will post this in the morning.
by: David Merkel