When I was younger, my dad used a lot of analogies to explain ideas.
It's a practice I've since adopted and find very helpful whenever I need to remember certain abstract concepts in more concrete terms.
Here's an idea that I've held for quite some time and once I'd love to share with you.
It's called a financial fortress.
What is a Financial Fortress?
Like it or not, but you're constantly under financial attack. I don't mean from infomercials trying to sell you things or salespeople trying to outmaneuver you at the negotiation table, I mean genuine bonafide financial emergencies.
Whether it's your kid coming home with some weird rash and you need to visit urgent care or your car rolls over a nail and now you have to spend $40 at the tire place to get it plugged, “minor” emergencies happen all the freaking time.
Then there are the major emergencies, like finding a lump in a place where lumps shouldn't be or sliding on black ice and totaling your car.
Each of those is an assault on your money. To protect yourself, it's best to think of your finances as a fortress and set up your defenses accordingly.
Your fortress is how you think of your money and how you'll deploy it in response to an emergency.
Moat – Checking AccountA moat is a body of water that surrounds a castle. Maybe it has a dragon in it or some other large hungry lizard, but mostly it's full of very hungry alligators.
As your first line of defense, your checking and savings accounts take the brunt of all your expenses. You might charge it to a credit card but you pay for it with these accounts. Your rent/mortgage, your utility bills, your grocery bills – all come from this account.
This is the account that also gets “replenished” first, with your paychecks or other sources of income.
The key to your moat is the liquidity (ha! get it???). You don't want it locked up in stocks or CDs or anything like that, because it's what you call on first when there's a need. Put it in a high yield savings account, get your 1%, and let it be. It's the cost of doing business.
Outer Wall – Emergency FundYou can handle the little things with your Moat, but your Outer Wall is what you use to defend against the bigger things. Car accident, job loss, major home repair, forced move, etc — these are the domain of your emergency fund.
The enemy has gotten past your moat and is not testing your walls. The emergency fund is crucial because these are expenses that exceed what you might spend in a month on typical expenses.
You should have a minimum of 3 months in an emergency fund and I prefer 6-12 months, but that'll depend on your assessment of your financial risks.
Inner Wall – Investment & Retirement AssetsThe raiders are over your moat, eaten your alligators, and breached that outer wall – here's where things get messy. If your situation is dire enough to require it, your inner wall is your taxable investment accounts and your retirement assets.
Fortunately, you will have seen this coming. Your emergency fund gives you time to prepare, hopefully six to twelve months, and so you can liquidate some of your assets in a more orderly fashion rather than having a fire sale.
You will want to liquidate long term taxable investments first (assets held for over a year), followed by short term (assets held for less than a year), then turn towards the retirement assets since those have a 10% penalty if liquidated before retirement.
There are exceptions to the penalties for early withdrawal, such as if it is a medical emergency, so review those carefully and adjust your liquidation schedule accordingly.
Your Knights – Credit Cards & InsuranceSprinkled throughout your kingdom will be your knights, there to deal with the smaller issues and give you a little breathing room (up to 30 days) as you organize your plan.
You shouldn't rely on credit cards to solve all of your financial issues, they come at a high price should you carry a balance, but they can be deployed as a useful tool in solving problems.
I try to pay for everything with a credit card, so I get the rewards, then I pay off the statement in full every month. It's a proxy for my moat and I get a small discount, as rewards, in the process. If you don't carry a balance, it'll give you a grace period as well.
Right next to my credit cards are various insurance policies that protect me against specific attacks in specific areas. I have auto insurance to protect my car, homeowner's insurance to protect my house, disability insurance to protect my income should I become disabled, travel insurance if I need it for my vacations, and life insurance to protect my family against debtors should I perish. This isn't an exhaustive list but should get you started on covering what you might need.
This is how I think about insurance – it buys me peace of mind. Should I suffer a covered event, insurance protects me and I don't have to rely on an emergency fund or credit cards for the short term.
If something is so serious that it blows through all of your defenses, credit cards can be the last line of defense. When things are dire, turning towards unsecured credit is better than the alternatives.
The High Tower – Your Hard AssetsTo finish off the fortress analogy, we have the high tower. These are your hard assets that you will liquidate to stave off ruin.
These are your possessions, jewelry, your car, your house… in that order. It isn't always the last line, you will want to sell jewelry and other possessions before you max out your credit cards or sell off retirement assets, but it applies to your house or your car.
Not an absolute rule but for illustrative purposes, I think you can see where I'm going.
Having this framework can help you see how complete your financial defenses are if you come under financial attack. I always like having financial emergency plans, like what you will do if you lose your job, before I need them. This analogy just paints the concept in a convenient picture.
What do you think? How fortified is your tower?