While interest rates aren’t very attractive at the moment, keeping proper cash reserves is still a critical part of your financial plan. This week, we’re going to go over how to build a cash reserve and how much you need in your emergency fund.
Why Do We Build A Cash Reserve?
Borrowing money or raising cash in an emergency always has a high cost. Credit cards can carry interest charges beyond 20% in some cases. Early IRA or 401(k) withdrawals come with a 10% withdrawal penalty on top of taxes while raising cash in your investment accounts can trigger capital gains.
Keeping a cash reserve is the easiest way to avoid the expense of raising cash for an unexpected event. If you follow the steps I’ll lay out here, building up your cash reserves will be faster and easier than you might think.
How Much Do You Need?
A cash reserve of between three and six times your monthly expenses is the tried-and-true rule of thumb in financial planning. However, many people often have a hard time calculating their monthly expenses.
An alternative (and easier) approach is to save between three and six times your monthly take-home pay. For many people, these two methods will produce similar numbers.
Finally, if you are retired or work in a potentially boom-and-bust industry (such as real estate), you may want to save even more. For some clients I’ve worked with in the past, the right answer was saving up to 12 times their monthly expenses.
Settling on the right number depends on how aggressive or conservative you are. Many people sleep better at night knowing that they have quick access to cash. Others want every other penny invested as aggressively as possible.
Do I Just Use My Checking Account?
For some people, opening a specific account, either a high-interest savings account or a money market fund is the best place to keep these funds. The higher interest can help you get to your goal faster. The lack of access to these funds – you don’t want them linked to checks or a debit card – makes it easier to keep the balance growing.
Many people use bankrate.com to find the highest rates and open an account online. I’ve had many clients find success with Ally Bank and Capital One.
Unfortunately, interest rates are insanely low right now. That means that even “high-interest” savings and money market accounts are not offering attractive rates. If access is more important than a fractionally higher interest rate, then using your checking account or savings account will do just fine.
How To Build A Cash Reserve: Getting Started
The most effective way is to set a savings target and automate recurring deposits that come out of your paycheck. You’ll want to look at the timing of any other automatic withdrawals you’ve already set up, such as auto or student loan payments. Make sure your emergency fund deposits fit in with both your pay cycle and your existing commitments, so you’re not left short during any part of the month.
Start as big as you think you can go, and then decrease it by 10%. Why not go big? Well, I’d like to see you start saving consistently instead of over-doing it, only to realize that your original goal was not sustainable. This is about building a habit, so it can all happen in the background.
If after a couple of months you are finding yourself unhappy and consistently short of cash, you can decrease it a little bit. However, most people find that having less money available just makes them more mindful of the ways they spend money and leads to organic expense reduction.
Boost Your Cash Reserve
On occasion, take advantage of any large sums of money you get – for instance, a tax refund, an annual bonus, or monetary gifts – to boost your cash reserves. It’s always a great idea to “splurge” with 10% or 20% of the total amount of the bonus, refund, or gift. That way, you can still enjoy it in the present. Put the rest directly into your cash reserve fund.
It won’t take you long to build up a large balance, and you may find that, even after you’ve secured yourself and your lifestyle, you may want to just shift your savings over to a new goal.
Bottom Line
Whether you call it a “rainy day fund”, emergency fund, or a cash reserve, make sure that you have sufficient cash on hand to cover some of life’s unexpected events, such as an accident, unemployment, or a big expense. It can keep you from having to access very expensive credit card debt or interrupting your current savings plans. The goal is to ensure you can recover quickly with minimal disruption and keep your life on track.
If you’d like help with determining how much cash reserves are appropriate for someone in your stage of life, then click here to set up a quick, complimentary introduction call to see if Prana Wealth is a good fit. We do still have the capacity to take on new clients.
As a fee-only financial advisor in Atlanta, we can (and do) work virtually with clients all across the U.S. and we’re here to help you when you’re ready.
The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but are intended to help manage risk and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax or financial advice. Please consult a legal, tax or financial professional for information specific to your individual situation.
