If you are living paycheck to paycheck or perhaps don’t know where your next paycheck will come from you know the feeling of being strapped for cash. While not a great feeling it is likely one of the most crucial realities required to move you along the path to financial success. Learning how saving money works and what it will afford you is a key step to building your wealth.
Think about the emotions you go through as you worry about how you will make ends meet. Fear, anxiety, restlessness, and depression are often tied to this experience. For many it can feel like they aren’t good enough or don’t have what it takes.
The good news is that these feelings can be the fuel you need to get out of your rut.
Have you ever wondered why you don’t feel this way after the bills are paid, or when you have money in the bank? It is because the uncertainties that are on the horizon carry less weight and the pressure of obligations has been relieved. You have room to breathe, a safety factor, a buffer.
How Buffers Work
When engineers design, they account for uncertainties in the form of safety factors. They will start with assumed loads for an application and introduce strategic buffers along the way. The chair you are sitting in for example may be designed for a 200 lb. person, but will it fall apart if someone that weighs 210 lbs. sits in it? No, why? Because it has been overdesigned with safety factor to account for fringe events.
Building your savings is effectively building a buffer for fringe financial events.
Great you say, so how do I build this buffer if I don’t have any money left over? Great question. The best illustration I can think of for this is provided in a great book called The Richest Man in Babylon. I will leave the illustration to the book but tell you that the simple idea is to pay yourself first.
How To Pay Yourself First
The principle boils down to adding money to your saving account immediately after money is acquired. Ok, that is step one. Step two is a bit harder, now that you have that money, leave it alone. When you run out of spending money you can not turn to these funds to buy whatever it is you think you need when your spending money is gone.
A tactic to help with step 2 is labeling your account as a Savings account, Emergency account, or Safety net account and setting it out of sight. For those with a W2 income this can be auto deposited to the account when you get paid. I did this early in my career and was amazed at how quickly the account grew.
After you get the above established you will find that living off of what is left becomes quite natural. It doesn’t feel as if you are living off less, you simply acclimate to living off what you have. Then as your savings buffer grows you will relieve yourself of the mental anguish that comes from living without money.
How Much Do I Need to Save?
Setting up and building your savings account is an emotional adjustment which shows you have self-control with finances. How much you grow your savings is something that will change along your journey. Initially we care more about the account growing consistently not how large it is. This could be $1.00, $10.00, $50.00, or $100.00 dollars a paycheck.
The amount doesn’t matter, it’s the practice of habitually saving that you want to establish. We will later discuss savings thresholds but until you have the root behavior in place the size of your account is not the concern. In fact, once this behavior is in place you will quickly blow past any thresholds that we create.
When To Use Your Savings Buffer
How will you know when its time to draw upon your savings buffer? You will know it is time if you have exhausted all other options. Your savings account is one that you don’t want to dip into quickly. It is there as a buffer to fringe events to protect you when crisis occurs.
Running out of money is not a financial crisis. Having excessive financial requirements thrust upon you in short order is a crisis. In the same way that the chair above is designed for a normal load can handle two times that load for a short period so to can you handle the momentary financial pressures through the use of your saving buffer.
What Do I Do Once I Use My Savings?
Once your savings has taken a hit you don’t need to panic. Your savings buffer did exactly what it was supposed to do, it provided you breathing room. Your habit of saving is hopefully well established, and you can continue building your account back up.
What If My Fringe Event Was Much Greater Than My Savings Buffer?
If this happens it will depend on the nature and extent of the event. These events by their nature are such a large Black Swan that to prepare for them is impossible. The pandemic could be considered for some the largest fringe event in their lifetime. It affected everyone differently and the financial consequences ranged greatly in severity.
With this type of event there is usually much more to consider than simply your savings buffer. I wish I had a better answer then this, but I don’t, each circumstance will demand its own attention. I would suggest that you should not live in fear of these events, by their nature you are not likely to experience many/any in your lifetime.
What Will Having a Savings Afford Me?
Once you have a savings in place and your financial buffer is great enough to handle the majority of situations you will need to begin thinking about what to do with your extra funds. By having liquid assets available you will be positioned to take advantage of opportunities that come your way. A great deal on a vehicle, home, or piece of equipment can all be opportunities you can take advantage of if you are positioned to make a large purchase. I have been fortunate enough to move on three such opportunities.
Using Savings to Get a Great Deal on a Vehicle
I was in the market for a new commuter car that would fit the family and had all wheel drive/4 wheel drive. My sister had an employee of hers that had a vehicle they wanted to part with quickly. The year was 2017 and the car was a 2013 Ford escape with 15k miles on it. It belonged to a family member that passed away and they wanted to liquidate quickly. Asking price was $10,000.00. It didn’t take long to work out the deal and write the check. Had I not had the money and needed to get financing the deal would have gone to someone else. We saved/acquired in equity between $5,000.00 and 10,000.00 because we were able to make the deal happen.
Using Savings to Get a Great Deal on a Home
Our fist rental home was purchased in much the same way as the above vehicle. Through someone we knew a home was going to go up for sale close to our current residence. It was one that was left abandoned and in need of a lot of work. You can read a bit more about it here: Lessons Learned From Rental Property. We made a cash offer that left enough room to do the needed work to get the place back in shape.
While this project took half a year and emotionally taxed us beyond what we expected it ended up being one of the best financial moves for our young family. We were able to purchase the house, finance the efforts to fix it and once complete set up financing that put all of the needed startup capital back into our pockets. The renters rent covered the note and we had what some call an infinite return on our cash.
The stars don’t align like this often but when they do you will hope that you have the resources to take advantage of them. I would guess that as few as three of these opportunities would be enough for many to retire on. I have yet to do a project that worked out as well as this one did.
Using Savings to Get a Great Deal on Equipment
One of my endgame aspirations was to collect enough equipment over the years to be able to manufacture anything I wanted through my retirement years. So, when a machine shop came up for sale at its asset value (again though people I knew) you can imagine my excitement.
Unlike the rental property there wasn’t as much built-in equity with this opportunity, but it also didn’t require any additional work. A fully working shop would offer the possibility of cash flow with minimal risk. if I could purchase the shop at the asset values, I would have the ability to generate revenue off the equipment, and the equipment would remain worth the cash used to purchase it. I would simply be tying up cash. If things went south, I could sell the equipment and get my cash back. I personally wanted to pick up everything over the years anyway so what did I have to lose.
Again, it boiled down to being a willing and able buyer when presented with the opportunity.
Wherever you are on your income journey be sure to check out The Four Stages Of Wealth Creation; From Clueless To Capitalist. We put this together as a guide for those looking to grow their financial acumen and take their next step towards financial independence.