Simple Finances: How and Why to Build Up a Cushion in the Bank

Every Tuesday is Finance & Family Day at Zen Habits.

Recently I began to do something in my bank account that would have been unthinkable to me a few years ago: build a (relatively large) cushion in my account, to allow myself to pay all my bills at the beginning of the month.

It makes more of a difference than you might think.

Building up a cushion in my bank account isn’t a complicated concept: instead of having just about exactly what I need to pay my bills (and transfer for savings), and then getting down close to $0 after all the payments are made and transfers completed, I decided to try to have a larger amount in the account, even after the bills are paid.

Let’s take a look at why, and then how to do it if you’re interested.

Why Build a Cushion
Let’s take a step back for just a second … to understand one reason why I want to build a cushion, you have to understand where I came from: it was only a couple of years ago that I was living paycheck to paycheck. That’s a scary thing for anyone, but especially if you have a family and only one income.

I’ve since improved my finances, mainly by living more frugally, paying my debts, and learning to save for an emergency fund.

But the cushion I’ve been building helps create a sense of even more security, knowing that in addition to my emergency fund, there’s money in the bank in case a bill is automatically deducted without my realizing it, in case I’m out buying something and realize I don’t have enough cash, in case there are charges I’m not aware of.

Besides security, though, there’s an equally good reason to build up a cushion in your bank account: it simplifies your finances. For example, if your cushion is big enough, you can pay all of your bills at the beginning of the month, instead of paying some each paycheck. And in my case, as I do freelance work and get some income from this blog, I get a bunch of checks a month, which can make bill-paying difficult.

There is real value in being able to pay all your bills at once and not have to worry about it for the rest of the month. Paying bills throughout the month can be complicated and stressful. Paying them all at once is simpler, easier, and saves time.

I’ll admit that I could be making more money by taking my money out of my checking account and earning interest or investing it. But I feel that this financial peace of mind, and simplicity, are both powerful reasons to keep that cushion in my account.

How to Build a Cushion in Your Account
So let’s say you are interested in building up a cushion in your bank account, and in simplifying your finances by paying all your bills at once, instead of throughout the month. How do you do it?

Well, there’s no one way, so I can’t give you a step-by-step guide, but here are my suggestions:

Cut expenses. This might sound obvious, so I won’t belabor the point, but if building a cushion in your account seems difficult, you will probably need to cut out a few expenses to do it. And that’s good advice for any financial goal, not just this one. Make it a goal to reduce your expenses by $100 or $200 a month (or more, if you think it’s possible). See what expenses you’re paying now that aren’t absolutely necessary, or what can be reduced. Look at the big things, like house and car and food. Look at the little things, like magazines and music and clothes and coffee and dessert.
Budget. If you’re having a hard time financially (and you might not want to hear this), you’ll need to create some kind of budget or spending plan. This allows you to plan for your expenses and know where you’re going to put your money. With a budget, it’s easier to see what you can cut, what’s necessary, and how to put a little extra aside for the cushion. It’s also good because then you know how large your cushion needs to be in order to pay all your bills at once. See these ways to simplify your budget.
Emergency fund. I’ve talked about how to create an emergency fund. Follow those steps, except that for the purposes of this article, you’ll want to do one of two things:

Create an emergency fund, then a cushion. Once you’ve saved up an emergency fund of about $1,000 (the minimum you’ll need to start with), then redirect those savings to build your cushion in your checking account.

Use your emergency fund as your cushion. Alternatively, use the emergency fund, temporarily, as a cushion. As long as you don’t spend the entire amount when you pay your bills at the beginning of the month, this is an easy way to get to that cushion quickly.

Little by little. If you can put $200 per month (or more) aside for your cushion, you can have a nice little cushion in a few months. It’s important that for the purposes of spending, you pretend that cushion isn’t there. I withdraw my spending cash, so I’m not tempted to use my debit card to withdraw the cushion. Setting aside a little at a time will take a little longer to get to your ultimate goal, which is to pay all your bills at once.
Refund. If, however, you get a windfall such as a tax refund, or a bonus at work, or a large payment from an extra project you did, or something along those lines, instead of spending the money, you should leave it in the bank as your cushion. This is the fast method to building a cushion … although as it’s hard to plan on this happening, you should do the little-by-little approach in the meantime.
Pay bills all together. Once you’ve built your cushion large enough so that it equals your monthly bills, you can now pay all of your bills at once (I like the beginning of the month, but your situation might vary). So set a day when you plan to pay all of your bills, go online, make the payments, transfer your savings deposit, and then withdraw your cash if you use the cash method. If you use a debit card for expenses such as gas, groceries, eating out, etc., again, you’ll need to be careful not to spend your cushion. So, pay all your bills on one day, then forget about it. Ah, the simplicity!
Use last month’s income for bills. Once you reach this point, from now on, when you get paid, you don’t spend it. You leave it in the bank to pay next month’s bills. From this point on, this month’s bills will be paid by last month’s income, and this month’s income will be used for next month’s bills. It’s a beautiful thing, knowing that you’ve got enough for more than a month’s expenses sitting in your bank account. Your finances couldn’t get much simpler.

If you liked this article, please bookmark it in del.icio.us or vote for it on Digg. Thanks!

See also:

Simple Finances: How and Why to Build Up a Cushion in the Bank

Photo by Todd Ehler

Every Tuesday is Finance & Family Day at Zen Habits.

It makes more of a difference than you might think.

Let’s take a look at why, and then how to do it if you’re interested.

I’ve since improved my finances, mainly by living more frugally, paying my debts, and learning to save for an emergency fund.

Well, there’s no one way, so I can’t give you a step-by-step guide, but here are my suggestions:

Cut expenses. This might sound obvious, so I won’t belabor the point, but if building a cushion in your account seems difficult, you will probably need to cut out a few expenses to do it. And that’s good advice for any financial goal, not just this one. Make it a goal to reduce your expenses by $100 or $200 a month (or more, if you think it’s possible). See what expenses you’re paying now that aren’t absolutely necessary, or what can be reduced. Look at the big things, like house and car and food. Look at the little things, like magazines and music and clothes and coffee and dessert.
Budget. If you’re having a hard time financially (and you might not want to hear this), you’ll need to create some kind of budget or spending plan. This allows you to plan for your expenses and know where you’re going to put your money. With a budget, it’s easier to see what you can cut, what’s necessary, and how to put a little extra aside for the cushion. It’s also good because then you know how large your cushion needs to be in order to pay all your bills at once. See these ways to simplify your budget.
Emergency fund. I’ve talked about how to create an emergency fund. Follow those steps, except that for the purposes of this article, you’ll want to do one of two things:

Create an emergency fund, then a cushion. Once you’ve saved up an emergency fund of about $1,000 (the minimum you’ll need to start with), then redirect those savings to build your cushion in your checking account.

Use your emergency fund as your cushion. Alternatively, use the emergency fund, temporarily, as a cushion. As long as you don’t spend the entire amount when you pay your bills at the beginning of the month, this is an easy way to get to that cushion quickly.

Little by little. If you can put $200 per month (or more) aside for your cushion, you can have a nice little cushion in a few months. It’s important that for the purposes of spending, you pretend that cushion isn’t there. I withdraw my spending cash, so I’m not tempted to use my debit card to withdraw the cushion. Setting aside a little at a time will take a little longer to get to your ultimate goal, which is to pay all your bills at once.
Refund. If, however, you get a windfall such as a tax refund, or a bonus at work, or a large payment from an extra project you did, or something along those lines, instead of spending the money, you should leave it in the bank as your cushion. This is the fast method to building a cushion … although as it’s hard to plan on this happening, you should do the little-by-little approach in the meantime.
Pay bills all together. Once you’ve built your cushion large enough so that it equals your monthly bills, you can now pay all of your bills at once (I like the beginning of the month, but your situation might vary). So set a day when you plan to pay all of your bills, go online, make the payments, transfer your savings deposit, and then withdraw your cash if you use the cash method. If you use a debit card for expenses such as gas, groceries, eating out, etc., again, you’ll need to be careful not to spend your cushion. So, pay all your bills on one day, then forget about it. Ah, the simplicity!
Use last month’s income for bills. Once you reach this point, from now on, when you get paid, you don’t spend it. You leave it in the bank to pay next month’s bills. From this point on, this month’s bills will be paid by last month’s income, and this month’s income will be used for next month’s bills. It’s a beautiful thing, knowing that you’ve got enough for more than a month’s expenses sitting in your bank account. Your finances couldn’t get much simpler.

If you liked this article, please bookmark it in del.icio.us or vote for it on Digg. Thanks!

See also:

Spewed into the world on 21 August 2007 in Finance & Family |
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Brilliant comments (47)

Laura Says:

August 21st, 2007, 6:19 am

I think the main advantage is the feeling that you have money in the bank, having a small cushion in a checking account lets you avoid the feeling of being broke.
On the other hand I’m always surprised at how many people keep way too MUCH in their checking account. I had an eternally-broke coworker with thousands in credit card debt who was keeping 8k in hers!

Hannes Calitz Says:

August 21st, 2007, 6:42 am

I found this article very helpful, thanks. At the moment I live from pay-cheque to pay-cheque, and your article has given me the knowledge to get out of the situation.

Again, thank you very much.

Balfour Says:

August 21st, 2007, 7:49 am

Is there any way to get followup comments by email without posting a comment? I have nothing much to say about this topic, since I’m pretty bad at it, and just want to follow the comments and be inspired. If there’s no way to get the follow up comments by email without posting, may I make a suggestion that it be created?

Leo Says:

August 21st, 2007, 8:20 am

Hi Balfour … sorry, I don’t know of a way to do that. Anyone with a suggested method would be appreciated.

Quint Says:

August 21st, 2007, 9:37 am

Leo - on the issue Balfour asks about - you could provide RSS feeds for comments. Then Balfour and others could subscribe via email to your comments feed.

I have more debt than I would like, my wife and I live on a single income, and my 9-5 barely covers my expenses. I made the decision a few years back to have at least 2 streams of income. I use the income from my consulting business to provide a cushion in my bank account. Recently, I had over $1,000 in vehicle repairs to our 2 vehicles, and the money in the bank covered it easily. It is a good, secure feeling to know that you have enough to handle emergencies.

I guess the point I am trying to make is that it is a good idea to do whatever it takes to build this cushion. It is hard to get out of debt if every unplanned expense hits the credit card. If you have to take a part time job on the weekends, start a small home based business or sell flea market finds on eBay, do what it takes to get that little foundation. It is a HUGE step toward eliminating fear and debt.

Rolf F. Katzenberger Says:

August 21st, 2007, 9:56 am

@Leo, Balfour: http://www.cocomment.com might solve the comment tracking issue

Debbie Says:

August 21st, 2007, 10:25 am

Another advantage of a cushion is insurance against mistakes. If you forget about one of your expenditures or just make a mistake in your math, then instead of going below zero and having fines, you just go below your desired minimum and nothing else bad happens.

I like to keep $500 more than I think I need in my checking account for this purpose. The problem is that if you’re the type to think, “I still have money in my account, so I still have money to spend” and can’t train yourself to think “I’m getting close to my desired minimum and so I need to stop spending,” then this plan totally won’t work.

Maybe you could keep the extra in an associated savings account, from which you could transfer the money quickly online when writing bills and then transfer it back when you get pay checks.

Sean Says:

August 21st, 2007, 11:22 am

I use a cushion myself, but I deliberately have *not* created an emergency fund. If you’re in my situation, you may want to follow suit.

I’m a U.S. homeowner, and I have a home equity line of credit ( http://en.wikipedia.org/wiki/HELOC ). This takes the place of a second mortgage and mine has a rate of 8.75%. It is basically like a high-limit credit card that has a balance that I chip away at every month. If I have some extra money left over some month, it makes no sense for me to park it in a checking account — even the ones that make about 5% annually — because by applying it to my heloc, I’m saved from paying 8.75% on it. This is, of course, much better.

If my wife or I lost one of our jobs, my recourse would be to make much smaller payments on the heloc. I’d effectively be using an 8.75% rate credit card for expenses incurred during a period where we lost a job. If we had a seriously prolonged period of time, we’d lose the house… but that would also eventually happen to somebody with an emergency fund that runs out. I refuse to live my life saving every penny for the unlikely event that I become unemployed for a decade straight!

An emergency fund is a type of insurance, but it’s not a cost-effective type for me to have given my job-loss risk. Strange as it may sound, my better and more responsible option is to leverage my house as insurance.

“Those who would give up Essential Liberty to purchase a little Temporary Safety, deserve neither Liberty nor Safety.” — Ben Franklin

Christopher Richards Says:

August 21st, 2007, 11:27 am

Those of us who are self-employed need to have more of a cushion. That cushion is a stress reliever, but I wouldn’t keep too much in the bank, because you can buy a money market fund, which is just a liquid, and get interest.

I have always lived a frugal live, and rather enjoyed it. At least I haven’t had to waste *so* much time working at things I don’t like. Having a cushion allows me to refuse some work, and oddly enough, it adds to my perceived value.

I tend to shun anything that is going to cost me money on a monthly basis. I do have to pay utilities, DSL, and rent that way. My phone is through Skype at $38/year.

Shawn Says:

August 21st, 2007, 11:28 am

I agree with person recommending associating a savings account. I use two accounts, checking and money market savings. I keep a decent cushion in checking and a much larger one in the interest bearing account. I have credit card and mortgage autopaid out of the interest bearing account since they are large and that one has the larger cushion. I need to be better about maintaining a smaller amount in checking so as not to waste the chance to earn interest.

Steve Says:

August 21st, 2007, 12:12 pm

The other benefit to building up cushion is that with some banks will waive your monthly fee wtih a balance of $3,000 - $5,000 sitting in your account. This may take a little longer but at least you don’t have to keep paying the bank to hold your money.

Another quickie is to get an ING Savings account. Their savings interest will be up to %3.75 by this Sept. Definitely worth setting up. I have 5 of these accounts and they don’t cost me a dime.

Food for Thought!

Stephen Martile
Personal Development with NLP
http://www.stephenmartile.com

Garry Says:

August 21st, 2007, 12:39 pm

Another advantage of having a cushion is you won’t need to waste time manually making all these payments. I have everything done automatically by direct debit so I never have to spend time on paying bills, or worrying that I might miss one. Of course I still watch my account regularly to monitor my balance and ensure there are no mistakes.

Lee Stranahan Says:

August 21st, 2007, 13:03 pm

Thanks so much for this great article…

I have a family with 3 kids and we have one income and we’ve totally totally paycheck to paycheck. Your ’small steps’ approach makes it seem possible and you’ve highlighted so many benefits that it makes it something I feel like I have to do…

Thanks again - nice job.

RxistKJ Says:

August 21st, 2007, 18:39 pm

“I’ll admit that I could be making more money by taking my money out of my checking account and earning interest”

Consider the Charles Schwab checking account which requires you to open a brokerage account but offers 4.25% interest. The brokerage account has no minimum balance and the checking account offers traditional paper checks, a debit card, as well as ATM reimbursement fees should you wander outside their preferred network.

Additionally, I have a HSBC Direct savings account which pays 5.05% interest compared to ING’s 3.75%. I keep a small ‘cushion’ in my Schwab account but the bigger ‘cushion’ is the HSBC account which I can transfer funds from within 48 hours if necessary.

Cass Says:

August 21st, 2007, 19:39 pm

You might have saved my sanity with this. Thanks! I’ve starred it in my reader so I can follow the steps,

Kerry Says:

August 22nd, 2007, 2:06 am

Leo,

I’ve been paying all my bills on the 1st of the month for about a year after to getting the idea from one of my co-workers who is a natural life editor. It has made my like so much more easier. One less thing to think about.

I love you site. Thanks for what you do!!.

Keith Says:

August 22nd, 2007, 2:29 am

One more extra point, don’t eat out at luxurious and lucrative restaurant and cafe. Cook at home, and perhaps survive on instant noodles every week until you managed to save up enough money for the day.

Hey, it works if you are serious on saving.

TP1024 Says:

August 22nd, 2007, 2:47 am

Wow, I must say that I’m quite surprised that this could be an issue in the first place. To me (Ok, not living in the US, but Germany, where we certainly have different attitudes.) it has always been obvious that you should have a cushion of money to pay your bills any time plus some money for any unexpected events. I mean, if you are able to pay your bills every month and end up with $0 by the end of every month, then you could just as well have $1000 by the end of every month, even without (permanently) changing anything about your spending behaviour whatsoever. Same goes for credit cards: if you can pay every purchase two months after you actually bought it and do that for 10 years straight, well, why don’t you just pay for it when you buy it, you obviously earned enough money to do just that for the last 10 years. (Unless you accumulated an ever growing pile of debt during that time, but then your problem is just that your either spending too much or not earning enough.)

A serious question: wasn’t all of that obvious in the first place?

Drew Says:

August 22nd, 2007, 3:07 am

Unless things are very different in your country I think there is some bad advice in this column.

Never pay a bill before its due if you are able to earn interest on the money in the mean time.

I have all of my expenses direct credited/debited from my “bill” account on, or just before the due date.

All my bank accounts earn some kind of interest, including my bill account. The bill account it topped up automatically each pay day by a preset amount, (and if need be I can manually add more).

By doing this I earn interest on the money each month, and that results in a very slow, but no impact on me, increase in my cushion.

Tony Says:

August 22nd, 2007, 3:28 am

Many years ago a roomate of mine taught me how to create a “cushion” in my checking account, albeit a slow way.

Every time I write a check I round the number up to the nearest dollar in my checkbook register. Every deposit is rounded down to the nearest dollar. This only amounts to a few dollars a month but over the years of doing this quite a nice buffer builds up painlessly.

Of course if you really feel the need to balance your checkbook to the penny this system won’t work but I gave that up years ago and have been happy ever since.

Carlos Says:

August 22nd, 2007, 3:37 am

I totally agree with TP1024. I’m from Europe too (Spain). Except for the mortgage and maybe car, we are used to pay everything upfront and live debt-free. We have few bills each month (utilities mostly) which are debited directly to the bank accounts.
People buying things before they have the money almost always run into problems in the long run.

Bryce Says:

August 22nd, 2007, 3:53 am

It’s also important to find an account with a good interest rate.

Leo Says:

August 22nd, 2007, 5:24 am

@Drew: While you might not agree with my approach, I don’t think it’s bad advice. Actually, I already addressed this point in the article, but let me go into a little further detail:

1. Yes, I could make interest instead of paying bills ahead of time. I could also take the cushion in my account and invest it in something that makes more money (more, even, than a checking acct with interest makes). However, I don’t think the interest gained would be of a very high value each month. We’re talking a few bucks a month.

2. In contrast, the time saved by paying all my bills at once is significant. Paying all bills at once takes (for me) at most 30 minutes. If I pay bills several times a month (paying each one when it’s actually due), then I’d estimate that would take an hour longer per month … each time I would have to log on to my bank’s site, check my balance, go to the bill pay section, and pay the bill. Even if I had them paid automatically, I’d want to closely monitor my account to ensure that they’re paid on time. If they’re paid all at once, automatically, I only have to monitor it once.

3. If I spend an hour extra paying bills because I want to pay them when they’re due, I’ve just cost myself much more in time than I would have made in interest. For example, say my time is worth $50 per hour (that’s not my figure, but an example), and I make $8 in interest a month from not paying my bills until they’re due. I’ve just lost $42. Even if I only spend 30 extra minutes paying bills, I’ve lost $17. Time has a cost.

4. In addition to saving time, paying bills all at once saves me stress by simplifying my finances. That’s actually the point of the article. And I believe that saving yourself stress each month is worth more than the few bucks you’d make in interest.

5. Of course, this is just my take on it. You might have your own priorities — saving time, stress reduction and simplification might not be as important to you as it is to me. In that case, don’t follow this guide — and that’s another point I made in the article: the steps I outlined are only if you are interested in the benefits I pointed out. If you’re not, move on. :)

Kim Says:

August 22nd, 2007, 5:51 am

I also agree with TP1024.

I’m from Europe too (Norway).
What’s wrong with having a buffer, or as I call it “The Zeropoint”.
If the zeropoint is reached (1000kr~166.67$), then I can’t spend anymore until next month. Pay all bill at the beginning of month is generally a good idea.
Okay, you may earn something like 0.0054$ for waiting almost to the due time, but you then have to live on the bleeding edge ALL THE TIME!!
And I also would like to add: If your buffer is getting big, then transfer all the money except for the buffer, do this right BEFORE your next monthly payment..

My last tip.. Pretend you don’t have the emergency accoun + buffer, then you start to live more economical from the first day.
(I know some people who live like kings in the beginning of month (about 7 days) and live like slaves the rest of the month…)

Bob Holness Says:

August 22nd, 2007, 6:18 am

An noone has mentioned the drawbacks of having a cushion: all the time inflation is positive, the money in your bank account is losing value. You would be better off investing any money you can in a vehicle that averages above inflation payout — most chequing accounts pay very little, if any, interest.

Leo Says:

August 22nd, 2007, 6:20 am

@Bob Holness: Read my comment above on this, in addition to what I said in the article on this topic.

Ben Says:

August 22nd, 2007, 7:12 am

Excellent article. You’re right that having a cushion, in addition to an emergency fund, helps one sleep at night knowing that the bills will be paid and there is a buffer for those unexpected costs.

One recommendation: you may want to use an online bank account that permits you to keep a savings account to earn interest on your money, and then use that money to make payments. I use ING Direct (see my name’s link) and perform monthly deposits and payments. It simplifies the process of paying bills, and I gain interest on the money at the same time.

Again, you’ve posted a great article!

Doug Says:

August 22nd, 2007, 8:22 am

http://www.daveramsey.com/

Get rid of the smallest loans first, and start working on the larger ones.

I am debt free (minus house and car) and have cash available to do whatever I want now. Great article. Save Save Save. Relax.

Dont buy frivolous things only to not need them later. Buy only things you will get the value out of.

headzero Says:

August 22nd, 2007, 8:29 am

Here is what I have been doing since ‘84. Set up a buffer in your checking account - say $50. Just go ahead right now and lower your balance in your check book by 50 bucks. This insures that you don’t get overdrafts because of a fee that gets charged and then a check for $10 goes through and you get a $30 overdraft fee (get free checking if you don’t have it already - save your money that way too). Every time you make a deposit, don’t right down at least $20 to add to the buffer. Every time you write a check subtract the check amount plus rounding up to the next closest $5 increment. If you ever need to dip into your buffer for something, the amount past zero (the amount written down - never try to run your buffer to $0 because you know its there)that you go, you need to repay the buffer double that on your next deposit. Always write down your checks as soon as you write them so that you don’t have to worry about reconciling your balance every month - you should always have more in the account that you think. If you do reconcile, its simply to find out how large the buffer is. Annually I come up with an extra $1500 by doing this. I have had one overdraft since ‘84, and it was the third check I wrote, back in ‘84. A pretty simple system really and doesn’t mean you have to do anything else different in your life.

jch Says:

August 22nd, 2007, 9:14 am

Had an ex-smoking buddy (haven’t smoked in over two years) working for an investment firm recommend to me during one of our simulatneous-rooftop-meetings a book called The Richest Man In Babylon…

http://en.wikipedia.org/wiki/The_Richest_Man_in_Babylon_(book)

Not a technical manual, but more a set of easy to read stories that really drive home the principle of “pay yourself first”. Taking the theme of “pay yourself 10% of whatever it is you make first” has helped me immensely. Of course, 10% means different things to different people, but anyone can do it. You take this money and either invest it or put it in an account separate from bill payments or discretionary income. In those two years, I’ve personally built an account worth well over 50K and still growing.

Michael Kaply Says:

August 22nd, 2007, 9:40 am

@Sean:

How about not having a HELOC at all? Then instead of paying off a loan every month, you could actually save and invest that money? All you’ve created with your HELOC is that if you have crisis, you’ll go into more debt.

The emergency fund is not just about unemployment. It’s about emergencies. It’s about cars breaking down. It’s about appliances breaking. It’s about medical problems. It’s about emergency home repairs. And it’s about job loss.

The last thing I want to do when I have an emergency is go into more debt!

Do you know how great it feels to know you have 10 or 15 thousand dollars in the bank just in case? And I don’t care if it’s not making a ton of money. That’s not what it’s there for. It’s insurance. Insurance doesn’t make money, it costs money.

Sean Says:

August 22nd, 2007, 10:16 am

Michael:

Some questions and comments:

1. Are you suggesting that everyone with a house and mortgage would be happier if they just rented and thus didn’t have to pay down a loan every month? I beg to differ.

2. One could argue that you should always put 20% down on a home so that they have no need for a 2nd mortgage or heloc… but that just means you spend more months or years living somewhere that you perhaps like a lot less. Is it worth taking a loan so that you can get into that house sooner? Often it is, but it depends on the person and the loan rate. There is no fixed rule.

3. I *am* investing that money I pay every month — in my home, an appreciating asset. That feels better to me than having a static sum in a bank account. But that’s me.

Here’s an analogy: Does it make sense to buy extended warranties? I only do for expensive things. Such warranties are guaranteed to cost you money on average — that’s why they’re being sold! But sometimes the peace of mind they offer outweighs the difference of their worth and cost. In my scenario that I described in my first post, the difference between the worth of an emergency fund (saving owed interest during an emergency) does not offset the cost (the owing of additional interest today on the heloc because I didn’t pay it down). I hope that makes sense

In the end, what we all need is to know where our money is going and to make financial choices consciously. There lies the true peace of mind.

Michael Kaply Says:

August 22nd, 2007, 11:02 am

@Sean

No, I’m suggesting everyone with a house would be much happier if they didn’t have a mortgage at all. I’m old school.

And are far as 2nd mortgages go, I would encourage folks to put down as much as they can, not necessarily 20%. I think too many people go to great lengths to take out additional loans to avoid paying PMI. I’d rather see people just put down 10% and pay PMI then take out 80/20 or 80/15/5 loans.

The problem, though, is you seem to be equating taking out a 2nd mortgage when buying a house and a HELOC.

At some point, your house had some equity and by using the HELOC, you took money out of your house. So your claim that you are investing in your house by paying your HELOC is a false dichotomy. The equity was already there. You chose to remove it by borrowing extra against your home. The interest you are paying is not going toward your house, it’s going to the bank.

You might be different than most, but my experience has shown that when folks have a fully funded emergency, it gives them a peace of mind that can’t even be described. The idea that when things happen they don’t have to incur more debt makes a huge difference on stress levels and lots of other things. And when things get really bad and they have to sell their house, they don’t have one more debt that takes the money they make from selling the house.

But as to your last comment, I totally agree. At least you (and some of the folks reading this stuff) are thinking about these things. Most folks don’t even have a clue :)

Andrew Says:

August 22nd, 2007, 11:18 am

My solution is to have two bank accounts, if your employer can direct deposit into 2 accounts. I budget for my recurring bills, and have the amount I need for those bills plus about $50 extra deposited into one account. I never touch this account, and all bills are paid automatically. The $50 extra into the account increases over time to create a cushion. The remainder of my paycheck is deposited into another account, and I can spend that money however I like, as long as I make sure I can pay for gas, food, spending, or whatever expenses are different each month.

Bill Bankcushion Says:

August 22nd, 2007, 12:29 pm

It’s most important to pretend the cushion isn’t there and think about your cushion amount as $0 left in your checking account. Say your cushion is $500, when you hit $520 left in your account, think about it as if you’re broke and only have $20 until your next paycheck. Don’t allow yourself to spend into it unless it’s an emergency and anything you take from the cushion is money you owe back to your account. Basically, that money is not yours to spend, and just start thinking that and it will stick with you eventually.

Chris Says:

August 22nd, 2007, 13:01 pm

Have a look at YNAB (You Need A Budget) at the link above. His approach to budgeting is just that — build a cushion (he calls it a buffer) so you can stop living paycheck to paycheck, live on last month’s income, etc. He sells an inexpensive Excel/OpenOffice spreadsheet or slightly more expensive Windows application to help plan out a budget with all that in mind.

amajamus Says:

August 22nd, 2007, 21:44 pm

I use to live check to check and it was terrible. Of course I didn’t know how terrible it was untill I saved money and quit living check to check.

Matt Wolfe Says:

August 23rd, 2007, 1:51 am

I started padding my bank account a couple years ago and it is simply great advice. It definitely makes life a lot less stressful. I take care off all of my bills at one time every month and don’t have to think about them again. It’s great.

Ed Says:

August 23rd, 2007, 12:00 pm

You can have your cushion in your checking account and get interest. ING Electric Orange pays 4% interest on checking, free bill pay, no minimums, etc. Great way to do what you are doing but getting interest too.
You can tell ING when to pay your bills so that you can earn the interest up till your payments are due like a previous poster had mentioned. You still pay all your bills at the first of the month, but have them sent out a couple days before the due date.

Unless my interest rate has just changed, the ING savings was at 4.5%, not as good as FNBO at 6% or E*trade, HSBC, etc. @ 5.05%, but for the interface and ease of use, IMO worth the 0.5% less for ING (maybe a different story if I had million(s) sitting in the bank).

Jason Says:

August 23rd, 2007, 12:32 pm

For an emergency fund, I would first determine my living expenses for one month, and set a goal to save that amount in my account. Should something happen, I will have 1 month covered, with no worries.

Ideally, you may want to have more than that in your emergency fund. Some day I’d like to save up 6 months worth of expenses in my emergency fund. That might be a little unrealistic, but think of the peace of mind that will bring.

Daiko Says:

August 23rd, 2007, 16:45 pm

Wow, what a great discussion of this topic. Here’s my 2 cents on two subtopics:

MORTGAGES
Michael may be right that everyone would be happier without a mortgage, but that’s a little like saying everyone would be happier without rent. In many cases, a mortgage can be a rent substitute with the side effect of creating some owned value. In that case it makes no sense to hold off for a cash purchase.

For example: While a mortgage may cost more than renting a one-bedroom apartment, a family may soon SAVE money with a mortgage on a house. In our neighborhood, the going rent for two bedrooms is more than our mortgage, and our payments are not subject to change. Also, our mortgage payments have been (on paper) an excellent investment.

EMERGENCY FUNDS
While 3-6 months of income is standard, I recently read a book called “America’s Cheapest Family Gets You Right on the Money” that adds a couple new twists. The book considers the 3-6 month standard to be “unemployment insurance” and advocates adding categories for car replacement, emergency travel, health emergencies, and home repair (obviously only if you own a home). Just picture being laid off the day before your car’s timing belt blows the engine, only to find that a parent died two days later and the family needs to attend a funeral 18,000 miles away. Suddenly, that 3-6 month cushion isn’t looking so comfy, and you’re still unemployed.

So I’ve adopted the plan for multiple emergency funds and set somewhat arbitrary standards for each category: 5-10% of the house value, $1-2000 per person traveling, $1-2000 per person requiring medical assistance, and $10-20000 for car replacement (I’m aiming for the lower numbers in the near term and the higher numbers “some day”). I’m only 45% funded for the near term goal, but knowing where I’m going helps.

Thanks for the great blog, Leo. And thanks to everyone else that makes the comments worth reading.

Lynda Kaufmann Says:

August 23rd, 2007, 21:54 pm

I think paying your bills electronically and automatically is a great way to manage your expenses.

As a Bank Manager I also have had to be on a strict budget at certain times in my life. After a brutal divorce I had to really cut back - or lose my home. When my paycheck went in my account, my mandatory bills went out automatically. I set-up my online banking to send myself a check of $25.00 a week. The process was free, I did not pay for a stamp, and once I cashed it I knew that was it for a paper, coffee, lunches, etc. I could save them and splurge on clothes, or cash it and go to a movie. Once it was gone, it was GONE.

We all need to use a little, or a lot, of self restraint and not buy into immediate gratification. After 12 months I had enough padding that I could support my household for 3 months no problem. It feels good - and now all extra goes to the principal of my mortgage.

Great article, great advice. More people should read and take heed. Do not be a slave to credit.

Jeffrey Hulten Says:

August 24th, 2007, 14:44 pm

Refund. If, however, you get a windfall such as a tax refund, or a bonus at work, or a large payment from an extra project you did, or something along those lines, instead of spending the money, you should leave it in the bank as your cushion. This is the fast method to building a cushion … although as it’s hard to plan on this happening, you should do the little-by-little approach in the meantime.

In my experience it is easy to get frustrated if you do this all the time. Depending on the size of the windfall I take between 10% and 25% for something nice for me and mine. That might be a nice dinner or a tech toy I have wanted, depending on the size of the windfall. This makes it easier for my to save the rest.

nancy (aka money coach) Says:

August 25th, 2007, 12:00 pm

A couple comments re: loss of interest etc., while providing the cushion:
1. Many chequing accounts eliminate the monthly fees if you have $1000 or more in the account. In Canada, this usually equates to an 8% savings or more (ie. not paying $80/yr in fees)
2. as Leo mentioned, money is not always about the technically smartest thing to do, but about peace of mind and a sense of security. With that established, it’s sometimes easier to do the technically correct/most lucrative with your other money.

Monica Says:

August 26th, 2007, 3:36 am

Who needs a cushion of money that loses value (unless, of course, it’s enough money to earn enough interest to be worth the trouble)? Credit cards offer that cushion. If there is an emergency, just charge it. It’s better to pay interest rarely (true emergencies are relatively rare) than to have funds that are neither used, nor producing sufficient interest.

If you are saving money, don’t live on noodles. Nutrition is important, and such a diet may deprive the body of important nutrients from better food, weakening the body and possibly making the person sick, either because of the nutritional deficiency itself, or because a weak individual gets sick more easily. And don’t forget that assets can be seized and bank accounts can be frozen, whereas nobody will ever be able to take back things that are enjoyable but gone forever, such as the meals you had last year.

Actually, they can do that kind of thing for the future, but that’s called prison. The whole idea of prison is about making people miss all kinds of things they enjoy, including eating whatever they want. Even there, the food may be better, or not any worse, than the diet of a person who lives on noodles. If nobody puts you in prison, don’t do that to yourself.

Diako Says:

August 26th, 2007, 9:31 am

Monica wonders:
Who needs a cushion of money that loses value (unless, of course, it’s enough money to earn enough interest to be worth the trouble)? Credit cards offer that cushion.>>

This is a common way of thinking about credit cards and Home Equity Lines of Credit. Still, having credit is very different from having savings. When the emergency comes, suddenly you find yourself with an unexpected payment and a “bonus” interest charge, at a time when you could better use the money to get back on your feet. You might think you can afford the interest on an emergency loan, and you probably can. But can you afford the principal payment? Often the answer is “no.”

Here’s an example of how a cushion can make a radical difference in how an emergency expense affects financial well being:

Assume that two families have their cars (both paid in full) fail catastrophically, and both families decide to buy a “new” used car that costs $9000. Family A has $20,000 in the bank as a cushion; Family B has $200 in the bank with credit cards as a cushion.

Prior to this, Family A held the money in a savings account and got approximately $70 in interest per month and Family B held their money in a no-interest, no-fee checking account. If all other income for the two families is identical, the difference in their situations appears to be $70 per month.

After the car fiasco, things look very different: Family A pays cash for the car. They now have only $11,000 in the bank and only earn about $38.50 per month in interest.

But Family B is in a much worse situation: they now have a debt of $9000 with a loan carrying a 5% APR. Their new interest payments of @ $37.50 per month might suggest the difference between the families is now $76 per month ($6 greater than before). However, family B also has a new monthly principal payment of $287, so they experience a monthly loss of $324.50.

With a single emergency purchase, the effective difference between the two families has ballooned from $70 to $362 per month, most of which is a minus for family B.

In addition, things will get worse if family B cannot cut enough from their monthly spending to afford that $324.50 car payment. Their financial situation will deteriorate each month, and their interest and debt payments may one day overwhelm them.

With this example in mind, the answer to Monica’s question is: everyone who can build a cushion needs a cushion, even if it is “losing value” sitting in the bank. And cushions are much more important for lower income families and individuals who have less “discretionary” income and will have a harder time recouping money spent unexpectedly.

On a positive note, even if you earn no interest on your cushion, you will find that it provides other benefits that make the effective interest greater than it seems. For example: at some point you will be able to pay your car insurance in full. If your insurer is like mine, there is a $2 processing fee per extra statement ($18 per year if you use all 10 of the extended payment periods). If your cushion is $1000, an in-full payment gives you an effective 1.8% APR.

Hoping you all prosper,

Daiko

Monica Says:

August 27th, 2007, 3:23 am

I have two questions then. Where can you even find an account that pays $70 per month for 20k? Where can I find that if I live in Canada? If you have that kind of money and interest, aren’t you better off keeping the money because it brings you interest every single month and paying on credit anyway even though, in the short run, you are losing money? It’s also a matter of discipline. It’s harder to save money again than to keep it.

Of course it would be better not to buy the car, but some people absolutely need it and this is just an example. But then, I never had a car and I live in Canada (I mention the country because you may point out medical insurance, which I have no need for). What do I need a cushion of real money (as opposed to credit) for in that case?

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