Understanding Your Financial Fortress

When I look at all of the freaking accounts that I have (brokerage, retirement, checking, savings, online savings, all times three), it makes my head spin. If all you have are the bare essentials: 401k, Roth IRA, a checking account, a savings account, an online savings account (like an ING or an Emigrant Direct) - then you’re already talking five accounts. Add a couple more that you may have picked up along the way (I have a checking and savings from when I grew up in NY, a pair from a previous job’s credit union), and a dozen accounts really isn’t all that unlikely. Heck, you might have five Sharebuilder accounts! (shhhh!) Anyway, all of these play a pivotal role in building your financial fortress and so walk with me as I draw down the complexities of the financial universe into one simple analogy: a medieval castle.

Your Moat - Checking & Savings

Your moat is your typical savings and checking accounts at your local bank. You pay your credit cards, your rent or your mortgage, your electric bill, and your grocery bill from this account. When you hit up the bars with your friends, this is the account you hit up. This is also the account that sees the majority of your direct deposit or your paycheck deposit (you really should be direct depositing). This account probably doesn’t give you much interest, maybe 1% max, but that’s okay because money in this account isn’t likely to stay in there for more than a month. When disaster strikes, you hope beyond hope that the money in this account will hold you through until the next paycheck.

The Outer Wall - That Emergency Fund

If the regular checking and savings are your moat, constantly emptying and filling with the best sludge and moat monsters you can find, then your emergency fund is that outer wall. Some people recommend three months of expenses, some recommend six, some go as far as a year of expenses. While those are good rules of thumb (they reach those amounts because they see job loss as the most prevalent emergency, so they put the fund’s amounts in those terms), I think that you should tweak it to whatever you may be concerned about. If you’re driving a beater of a car and know that it’ll be replaced soon, maybe you increase your emergency fund allotment. I would avoid going less than three months of expenses though because this is for emergencies after all and you won’t see these suckers coming.

Your emergency fund will probably be in something semi-short term, not 0 day liquid (I don’t know if that’s a real term but I mean that you can get at the cash immediately), and so something like laddered CDs/Bonds or an online savings account would be ideal for your emergency fund. Online savings accounts aren’t 0 day liquid, it takes a few days to get the money out (usually a week), but it’s a guaranteed rate of return and they’re better than certificates of deposit and bonds (which have early withdrawal penalties).

The Inner Wall - Investment & Retirement Assets

If the raiders have breached the outer wall, they’re now up against your inner wall - your investment and retirement accounts. Whether it’s a 401K, your Roth IRA, or just the stocks and funds you stick your extra money in, these will be your accounts that you tap into in the event of disaster after your emergency fund. After the daily accounts and the emergency fund, I like to invest the remainder in some mutual funds so that they can grow a little faster than 5% (going market interest rate for online savings accounts) and I believe this is the correct strategy. The 401K and the Roth IRA are obviously less liquid than a standard brokerage account since you’ll pay penalties on some of that for early withdrawal, but unfortunately you may not have a choice if a significant disaster strikes. Luckily, for certain emergencies, namely medical, some of those penalties are reduced.

The Guards - Credit Cards

As I was drawing this analogy, I knew that plenty of people, in the event of a disaster, turn to credit cards a short term solution and so I put credit cards in the very last possible position they could be - right before the high tower. See, if you need a $200 car repair and just need to float yourself some money, you can often turn to your credit card instead of tapping your emergency fund reserves. In that respect, you can think of the guards as the soldiers you put at the front lines as well as the final line of defense. So, don’t think that I’m advocating credit cards as a last line of defense, this is merely the absolutely last place they could go as you will see in a moment.

The High Tower - Your Assets

Lastly, to finish out the castle analogy, we have the high tower: your car, your house, your spouse (just kidding), your jewelry, your flat screen television; if things have turned so far south, sometimes you have to sell some of your assets to make it to next month. Of course, like all analogies, this isn’t an absolute rule - should you raid your retirement fund or sell your flat screen television? I would argue that you should pawn the television and cancel the cable before you raided a 401K, but what about a car?

While nothing in life is as simple as an analogy and it may be a stretch to try to fit every last aspect of your finances into a castle analogy, I thought it would be fun to take a look at it from this perspective.

Images courtesy of akbar1947, Christiaan L, archidave, scuba04, BOND159, and Beatnikside.