1. Why do I need short-term savings?
Well, you could live off of your credit card if you lose your job, but then you get to pay back your shortsightedness at 18%. Many's the family that found itself in bankruptcy as the result of just such a plan. You may not know exactly what's going to happen, but bad stuff happens often enough that you need to be ready when fate hits you in the face with a dead fish.
You also need to save up for foreseeable expenses. Vacations, new cars, and weddings are all predictable. You've got two choices: 1) save up and earn interest, or 2) borrow the money and pay (at a much higher rate) interest. Seems like a no-brainer to us.
2. How much money do I need in short-term savings?
Well, that depends on your situation -- not that we're weaseling out of an answer, but there's no formula that fits all cases.
Generally, you will want to have at least three to six months' worth of living expenses in an emergency fund in the event that fortune frowns on you in one of its many, many ways. How much you need depends on your financial responsibilities. If you're a programmer who's footloose and fancy-free, a couple of month's worth may be enough. If you're a performance artist who's the sole support of six children and your aged parents, you'll probably want to aim for a year's worth of expenses in ready cash.
Beyond your emergency fund, any funds you'll need within three to five years should not be at risk in the stock market.
3. Why shouldn't I just keep all my savings in the stock market?
We are the biggest supporters of the idea that all of your long-term money should be in the stock market. But over the short term, the market is too volatile for short-term savings. Buying stocks for short-term gain is really speculating, not investing. Would you have wanted to have your emergency fund, or your house down payment, or your kid's tuition in the Nasdaq at its height on March 10, 2000? If you can't afford or can't wait out a 30% drop in the value of your savings, keep it out of the market.
4. What can I invest my short-term savings in?
There are a wide variety of instruments for your short-term savings, including money market accounts, certificates of deposit (CDs), government and corporate bonds, and bond mutual funds. We cover these different choices in greater depth in Where to Stash Your Cash.
5. What kind of return can I expect to get?
At least 100% a month, baby! But only if you follow our proven formula, available now for the low, low price of...
Oops. Sorry. We've been watching too many late-night infomercials.
Your return will vary, of course, but right now money market accounts are paying less than 2%. CD rates depend on how long you are willing to tie up your money, but short-term CDs start out about the same as money market rates and go up in small increments as the term gets longer. Corporate bonds tend to pay more than CDs or Treasury bonds, depending on the risk of the bond. You can get a great interest rate on companies that are heading toward Chapter 11! (Not surprisingly, this isn't a strategy we Fools would recommend.)
Compared to the average return of the stock market, your return on your liquid savings won't be very impressive. Except when the market is in a bad mood, of course. And then that 2% to 5% will look like a fortune.
For more on making the most of your liquid loot, visit .The Motley Fool Savings Center