So, you’re saving for an upcoming expense. Maybe it’s a home down payment, a new car, a vacation, or a wedding.
You are planning for the future and saving ahead of the expense. This is a great money habit.
When an expensive event comes due, it’s more enjoyable when the money is there.
Money stress evaporates. No debt, no future payments, no stress.
And limited stress means more capacity for you to focus on life, including the event/thing you are spending on.
But with inflation high, I’m sure you want to retain purchasing power while limiting the risk of loss.
In this post, I’ll cover short-term savings options to help you find the best place to put your money to meet your short-term goals.
Table of Contents
What Are "Short Term" Savings
I define short-term savings as any money needed within the next 5 years.
These short-term goals are best met with Sinking Funds, where you save a target amount each month before the specific upcoming expense. Then, you pay for the expense in full, with cash.
I like sinking funds. They provide a smoothingeffect on your expenses. They also prevent you from stealing from future self by taking on consumer debt.
Short-term savings include your emergency fund. Although, the emergency fund deserves some extra care.
You never know when an emergency will hit, by definition. Therefore, you treat all the money in the emergency fund as if it could be required tomorrow.
Savings Goals and Time Horizon
I use the word “time horizon” in this post. It refers to the amount of time between the present day and when you need to spend the money.
Say you have money sitting to buy a pet turtle in 3 years. Your time horizon would be 3 years.
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A Battle Against Inflation
At historic inflation rates of 2.7%, you will lose 11% of your purchasing power in 4 years.
The situation is even more drastic in 2022 as annual inflation floats around 6%. This issue becomes more problematic as your time horizon increases.
So, where do you put this money to limit inflation’s impact while minimizing the risk of loss during this short time frame?
This is where low-risk interest-producing assets come into play. By loaning your money to others, you can earn interest on your money to reduce the impact of inflation.
I’ll talk more about how to pick the right short-term savings option below.
Traits of Good Short-Term Savings Assets
I’m prone to get grumpy when I spend large amounts. To remain happy, I build short-term savings throughout the year in a sinking fund.
This is especially helpful come Christmas time.
Come Christmas, I want money to be easily accessible when I need it (liquidity), and I don’t want it to drop in value (risk).
Liquidity and risk are the two key factors when picking a short-term savings option. These characteristics will drive where you put your short-term savings.
“Liquid” may seem like an odd term. How can the money be “liquid”?
It makes sense to me when I think of the flow of money. A liquid asset is one where money can flow in/out with ease.
Liquidity factors include the length of time it takes to access your money and the cost of access. You want to be able to access short-term savings quickly and at a low cost. These characteristics define liquidity.
A house and a car are examples of illiquid assets, as they take effort, time, and money to sell.
Time Horizon and Liquidity
Not all savings options have to be liquid throughout the entire time horizon. For example, locked-in savings vehicles like GICs may be okay for a short-term savings goal even through they are super illiquid.
If you want to save money for a vacation in 3 years, you could buy a locked-in GIC (CD in the US) for 3 years. It’s super illiquid during that 3-year period – you can’t access it.
But that is okay, as long as you are good with eliminating the option to take the vacation early. Illiquid assets like GICs and CDs limit your optionality in the timing of your future expense.
On the other hand, you have an emergency fund. This needs to be the most liquid of them all. A GIC would be useless in the case of an emergency when it’s locked in.
I use cash for my emergency fund. It gives me the flexibility to buy items, like a car or fridge, used off Marketplace or Kijiji for a low cost.
For more frugal living tips, check out 13 Frugal Living Tips to Save Time, Money, and Energy.
The amount of liquidity in your short-term savings option will depend on your time horizon and the certainty in the timing of the future expense.
Risk can be defined in multiple ways.
For short-term savings goals, I define risk as the probability of failure to meet your savings goal(s). Pretty straightforward.
To reduce this risk, you need a stable investment that does not fluctuate in value, not an asset with rollercoaster-like price characteristics.
Consider someone in 2005 who invested savings in the total US Stock Market for a down-payment on a home they must buy in 2009.
That person would face a 25% loss. That’s no fun. They failed to meet their down-payment goal.
Money saved for a short time must be in low-risk assets. The stock market is not a place for short-term savings.
Instead, the stock market is great for money that is not required for 10+ years. Over long time horizons, sitting cash will lose serious purchasing power to inflation. So cash becomes risky if you define risk as the ability to meet your goals.
But the risk of loss for stocks goes down as we zoom out. You can see this in the snip of the US stock market below.
$10,000 invested in 1982 grew to $666,014 in 2022. During this time there were multiple crashes greater than 30%.
We can also look at Monte Carlo simulations.
Say you invest $1,000 today in stocks for a $1,000 expense in ONE year.
There is a 27% chance you will end up with less than $1,000. If you increase the horizon to three years, the probability of failure falls to 20%.
Best Places For Short Term Savings
The best place to put short-term savings is in low-risk assets. They include:
- Cash. Under a mattress, checking account, or a high-interest savings account (HISA).
- Guaranteed Investment Certificates (GIC), or Certificates of Deposit (CD) in the US.
- Money Market Funds
- Short Term Bonds
Let’s go through each asset type. Since these are all short-term debt assets, the interest rates will be linked to the central bank’s overnight rate.
Cash In An HISA
I don’t have much to say about cash. It’s liquid and low-risk. This is great for emergency funds or any money needed within a few months.
Ideally, your cash would pay some interest. Therefore, a High-Interest Savings Account (HISA) is often the best bet.
Technically, you loan your money in a checking account or HISA to your bank. Then your bank loans this money to others at a higher interest rate than they pay you.
Cash held in HISAs and checking accounts is especially low risk as these deposits up to $100,000 are insured by The Canadian Deposit Insurance Corporation (CDIC) if your bank is a member institution.
If your bank fails, you don’t lose your money. The same applies to my American friends via the FDIC, however, I’m not sure of the max insurable amount.
High-Interest Savings Accounts ETFs also exist. These are like savings account that trades like a stock on an exchange. Such products can be held in a tax-sheltered account like the TFSA.
These guys are not CIDC insured, and therefore you take on slightly more risk than investing in a regular HISA, but you get a better return.
To learn more, check it this PWL Capital Whitepaper on HISA ETFs.
Money Market Funds
A money market fund will invest money in quality short-term debt assets and cash-like assets. But I want to be clear that a money market fund is not cash.
Such investments include very short-term bonds, CD/GICs, and Corporate Commercial Paper. These very short-term debt assets have high credit ratings and low risk.
The fact that they are short-term loans reduces interest rate risk. I talk more about why this is the case in the section on short-term bonds.
However, money market funds are not CDIC or FDIC insured. They are therefore higher risk than straight cash in a HISA or checking account. But you will receive a higher interest rate than an HISA or checking account, with fairly good liquidity.
These guys come in three main options:
- A money market mutual fund
- A money market Exchange Trade Fund (ETF)
- A money market account.
A money market ETF and a money market mutual fund are very similar, with different trading mechanisms. Learn more about ETFs vs. Mutual Funds.
A money market account is a bit different. These accounts offer a similar user experience to the HISA. Cash can be added or removed easily at any time and you can even get a debit card for these accounts. I’ve never held one and they don’t seem too common in Canada.
The value of a money market fund stays constant and the fund pays interest payments, normally monthly. Expect higher interest rates than you see from a checking account or HISA.
Money Market Fund Liquidity
As for liquidity, it can take up to three business days to have usable cash after the decision point to sell a money market ETF or money market mutual fund.
That’s not ideal for an emergency fund. But it works fine for most other upcoming savings goals as long as you can think ahead by 3 days. I’m pretty sure you can do that.
Short Term Bonds
A bond represents a loan to a company for a set period of time. In exchange for giving away your money, you receive a fixed interest rate for the duration of the loan. When the loan is over (matures), you receive the original principal back.
It’s essentially the same as a GIC. Unlike GICs, you can sell the bond before it comes due at a “market price”.
This market price fluctuates when interest rates go up and down. When interest rates rise, new bonds are available that pay better rates.
Less people want your lower-paying bond, and the market price of your bond falls. Sad, I know.
- As interest rates rise, bond prices fall.
- As interest rates fall, bond prices rise.
They are inversely related.
The level of interest rate risk increases with the bond’s maturity length. Therefore, short-term bonds have lower interest rate risk than long-term bonds.
>Short-term bonds with good credit ratings can be okay for short-term savings goals between 3-5 years.
Interest rate risk is eliminated when you match the bond’s duration to your time horizon. This is called “duration matching”.
Finally, a bond is illiquid during its term, but a fund of many bonds is far more liquid.
Example: Bond Duration and Interest Rate Risk
I can best show this through an example of two different bond index ETFs during the period of rising interest rates in 2022.
The effective loan duration is 7.35 years for the Canadian Universe Bond Index Below. It’s down -9% over the same 3-year period, which is a lot for a bond drop.
Now check out the Short-Term Bond Index below, with an average duration of 2.74 years. It is down by 1.26%. Note the difference in scales on the vertical access.
I can think of two other factors regarding short-term savings. These include the time flexibility of your spending goal and taxes on interest income.
Goal Timing Flexibility.
Do you have the flexibility to move your spending goals into the future? If so, you can afford to take more risk.
A pre-set wedding date or a vacation with friends can’t be moved. But the date of a home purchase could be flexible, depending on your unique situation.
I, for example, currently rent and invest. I’m not in a rush to buy a house, so I’m cool with renting and investing for a few more years while the market recovers. My flexibility enables me to take on more risk.
Taxes and Tax Sheltered Accounts
All the short-term savings options covered generate interest income. I’m talking about bonds, HISAs, GICs, and money market funds.
In Canada and the US, interest income is taxed at your marginal tax rate.
By holding $10,000 in short-term savings at a 3% interest rate, you will receive $300 of interest income. At a 30% tax rate, you will lose $9o of that income to tax and will receive $210.
The only way to avoid tax on this interest income is to place the money in a tax-sheltered account, like a TFSA (Roth IRA in the US).
Thanks for reading. The action of setting short-term savings goals with sinking funds improves planning habits and keeps you out of debt. These are key to building wealth and limiting financial stress.
- Stocks and long-term bonds are too volatile (risky) for short-term savings. You risk failure in meeting your savings goal.
- Emergency funds are best left in a cash-like asset that can be accessed immediately, like now. A HISA or checking account meets this requirement.
- Risk and liquidity are two factors to consider when evaluating different investment options.
- I covered bonds, GICs (CDs for Americans), Money Market Funds, and HISAs.
- Interest income is taxed as regular income. You will shelter yourself from this tax if the interest-bearing assets are placed inside a tax-sheltered account like a TFSA.