Everything you need to know about having a short term capital reserve

Now that you know the importance of having an emergency fund, we can move on to talking about your upcoming big-ticket purchases. Remember, you need to have your emergency fund sorted out first!

car keys

Most of us have some kind of an idea of what we want to spend our money on. Every now and then we like to treat ourselves and buy something more expensive – it could be the latest smartphone, a new Vitamix blender or a new car. Other times it could be some repair work on your home or home renovations. These expenses need to be budgeted for and appropriate savings set aside. As mentioned earlier, you should not dip into your emergency fund for this kind of spending money or more formally for this kind of capital expenditure.

I think most people tend to “wing it” when it comes to budgeting. This can work for some but it isn’t always the best route as you might overlook one expense by paying for another one and can run into trouble later. This post will tell you what you need to keep in mind to effectively manage your upcoming big-ticket expenses.

What do you mean by short-term expenditure?
A good rule of thumb is to think ahead of the next 3-5 years and think about what upcoming expenses are on the horizon. Going any longer than that will make your estimates less accurate and therefore less useful. However, we can get a relatively good idea of what the future holds for us in the next few years. This could be an upcoming dream holiday, saving for a mortgage deposit or a new car purchase.

Short term can mean less than 3 years and also for more than 5 years. It depends on what you have planned for the future and where you are in your life. For example, a young couple might be thinking about buying their first home but their parents would be thinking about repairing the roof or building an extension.

How much should you set aside for your short-term capital expenditure?
This is an impossible question to answer as everybody has different upcoming expenses. Simply work out what things will cost over the next couple of years and add it all up. Simples.

Should you borrow?
In short, no. I’m anti-debt, especially against consumer debt. If you need to borrow money to buy a smartphone, then you shouldn’t be buying that smartphone. You can’t afford it. Stay away from debt wherever you can and consider alternatives such as buying second hand or opting for cheaper goods and services.

Where should you keep your short term capital expenditure?
One option would be to simply keep it in cash, similar to your emergency cash. However, the key distinction here is that you know when the big-ticket expense will happen. You also have some control over the expense as you may decide to delay it, bring it forward or cancel altogether.

Because of that added control, you can now think about using safe short term investments for this type of expenditure. If you have a £10,000 expense coming up in one year’s time, then you could put £10,000 into various bank accounts to earn some interest. You can even decide to lock the money away for 6 or 12 months or even longer to earn better interest.

banks

There are many banks and building societies who are more than happy to take your money and pay you a bit of interest. There’s no point in recommending a particular bank’s account as the offers keep changing all the time. Make sure to check a particular account’s terms and conditions as quite often they’re something like “earn 5% interest on up to £2,000 of your savings”. You might need to open a few accounts with several banks to maximise your interest. This is not for everybody – especially not for people who hate opening accounts and can’t be bothered. I know my girlfriend would rather earn zero interest or even pay for the privilege of having her money held in an account if it would prevent her from having to fill in a form which asks for her address details covering at least the last 3 years (speaking from experience here).

person holding coins

I’m sure you’ve noticed that interest rates are very low right now. The Bank of England lowered its interest rate to 0.1% and the Federal Reserve (in the US) lowered it to 0.25% only a few weeks ago. Inflation is at 1.7% and 1.5% in the UK and US respectively right now. You might think that keeping money in cash will guarantee a loss in real terms as you are unlikely to beat inflation with your cash savings. This is very true and I think it’s unlikely to change any time soon. However, this does not mean that they do not have a place.

Investing your money in the markets will introduce risk to your capital and you can end up with less than you started with. This is especially the case over the short term. To be clear, when I say short term I mean anything below 5 years. There will be a post in the future shining some more light on this but the gist of it is that the longer you’re invested the lower the probability of suffering a capital loss. This is because markets have an upward slope as they tend to go up over time.

One option is to consider using a savings platform. These are essentially cash management platforms, where you create one account (a hub account), deposit your money and then select various bank accounts to deposit your money into. The benefit is that you only open one account with the platform and then pick the various bank products you wish to split the money form your main hub account. This removes the need to fill in forms to open new accounts with new banks and building societies. You will also have an easy overview of where all your money is held and how much interest you are earning. Bigger savers will also benefit from added security as UK deposits are FSCS protected up to £85,000 per bank, building society or credit union – you can increase this by spreading your savings over several institutions.

The only downside is that these savings platforms charge for their services. This tends to be 0.25% p.a. or similar on anything held on the platform. So, you should expect to earn slightly lower interest than going directly to the providers with your savings.

Taking the above into account, if you choose to invest some money which you need in say two years’ time, then you might actually end up with less than you have today. There’s no need to risk your hard-earned cash like this.

You can also look at the savings products offered by NS&I for your short term investments. These are backed by the UK government and its printing presses. Therefore, your money will be as safe as the UK government.

To be clear you should not invest money in the stock market where you intend to access it within the next five years. Also, avoid any peer-to-peer (P2P) investments as it can take ages to get your money out of these platforms (speaking from experience).

Interestingly, I heard of a creative/unusual way of earning more interest on your money. This example is from Sweden where the local central bank i.e. Riksbank has kept interest rates at zero or below (yep negative) for the last five years. However, it is possible to overpay your taxes in Sweden and earn a minimum of 0.56% p.a. interest on these payments. This has resulted in massive overpayments and a budget surplus a few years ago. They changed the rules and now Swedes don’t earn any interest on their overpayments and many received refunds.

That example is not an attempt to encourage you to think outside the box to increase your interest. There’s plenty of scams out there. If it sounds too good to be true, then it’s probably a scam. For example, anybody who offers to take your money in exchange for a guaranteed 10% annual return, is full of it. Stay away!

Summary
I hope the above has convinced you to keep your short term capital expenditure in cash or low-risk cash investments. You now understand why it’s important to keep this money separate from your emergency cash and why it should be in safe investments. I have shared some of my ideas on how to invest your short term money and what kind of investments to avoid. Go ahead and check out some of my ideas (Google is your friend).

TLDR
Short-term capital expenditure includes your future big-ticket expenses which will happen within the next 5 years. You have control over this type of expenditure and that’s why you can choose to invest in safe cash investments to cover it (as you will be able to access your money when or before you actually need it).

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