Why You Need It
One of the few certainties in life is uncertainty itself. When it comes to your personal finances, it is critical to build and maintain a ready cash reserve that can be used to address the inevitable, unexpected expenses that all of us encounter. Who can predict the timing of significant family medical expenses, major car repairs, short term disability, or even the loss of a job? Without a source of cash to deal with these challenges, you can get trapped into the use of credit card debt that is not paid off at month’s end, only to begin accumulating high-interest rate charges. While it is important to start systematic saving for retirement as early as possible, the establishment of a cash reserve may be a higher priority. Let’s explore some guidelines for determining the recommended size of your cash reserve and some thoughts for building it up.
How Much is Enough?
Interest rates remain at historically low levels. Given the low rate of return that you can expect to earn from cash deposits held by a financial institution at this time, it can be frustrating to maintain a cash reserve. Determining the appropriate level of cash reserves for your unique circumstances takes on added importance since cash could always be invested for the long term with a higher expected return than currently afforded by savings and money market accounts. A general rule-of-thumb is to hold about six months of typical household expenses. For example, if your monthly living expenses are $4,000, you need about $24,000 in reserves, after you have paid that month’s bills. However, this guideline should be tempered by your circumstances. If you feel less secure in your job, your income is seasonal, or you are a commission salesperson, consider increasing your cash reserve to guard against these uncertainties.
Your cash reserve should be enough to hold you over beyond the elimination period specified by your short- term disability coverage and the potential payment of deductibles for your auto and homeowner’s policies. Finally, if you expect significant expenditures in the next four or five years, reserve this amount in addition to the base amount. Market cycles can often exceed two or three years; you don’t want to be forced to liquidate some of your investment holdings during a bear market to meet spending needs.
Once you have reserved enough cash to cover potential spending needs for the next few years, consider investing any overage for the longer term. While cash earns some level of interest in most checking and money market accounts, when the effects of taxes and inflation are considered, most liquid cash accounts do well to preserve their original purchasing power. For this reason, it is best to invest excess cash reserves when there is an expected holding period beyond that of a typical market cycle.
Tips for Building Your Cash Reserve
Find ways to set aside small amounts of cash every month by building savings into your monthly budget. This assumes that you are not carrying credit card balances. If you have credit card balances unpaid at the end of the month, paying down this typically high-interest rate debt can take precedence over building a cash reserve. For most of us, it is impractical to build your cash reserve quickly; most of us simply can’t afford to do so given monthly spending requirements. But most of us can reduce our spending by five to ten percent if we are truly committed to set aside a bit of cash each month. For those who are significant contributors to an employer’s retirement plan that provides a matching benefit, consider suspending contributions beyond that required to qualify for one hundred percent of the match, until an emergency cash reserve has been built. Another option is to establish a home equity line of credit that can serve as a ready source of cash. However, be mindful that this is a variable rate loan whose rate can increase and that your home is at risk if you can’t satisfy the lending institution’s requirements.
Follow The Welch Group every Tuesday morning on WBRC Fox 6 for the Money Tuesday segment.
Fox 6 Talking Points
- Why does everyone need a cash reserve?
- How much is enough?
- What are some tips for building a cash reserve?
Woodard Peay, MBA, CFP®, is a Partner and Senior Advisor at The Welch Group, LLC, which specializes in providing Fee-Only investment management and financial advice to families throughout the United States. Woodard is a graduate of Vanderbilt University and holds a Master of Business Administration from The University of Alabama and is a CERTIFIED FINANCIAL PLANNER™. In addition, Woodard appears as a guest on local television stations as an expert on various financial planning matters. More information about The Welch Group and important Disclosures can be found on our website. Investing in securities involves the risk of loss. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment or investment strategy will be profitable or equal any historical performance level(s). Consult your financial advisor before acting on comments in this article.