We all need access to cash! If you are thinking, “I hardly ever use cash anymore,” you are right. Our use of cash each day is limited. We use debit and credit cards for everyday purchases, but we need cash in our accounts to cover those expenses. When using a debit card, we are allowing a withdrawal from our checking account. Using a credit card is a short-term loan from a bank with a promise to pay in full or experience interest charges. To achieve financial health, it is best to maintain cash to cover all debit and credit card transactions. But, how much cash do we need so that we are ready for whatever comes up?
As a Certified Financial Planner™ professional, I work with clients with varying preferences for maintaining cash in their accounts. Some clients spend all their monthly income and would like to accumulate cash. Some clients have large amounts of cash in their checking account. Some maintain large cash positions in their brokerage account. So, what is the right amount? Well, that depends!
Most financial planners agree that we need to maintain an emergency fund, which is between three and six months of living expenses. The emergency fund is used when your work is terminated and you no longer have income from that job. Having funds set aside for this “rainy day” can provide some peace during a challenging period. Having the ability to calmly look for your next work opportunity really helps!
I provide one caveat to this rule. Not all monthly expenses are necessary. Consider the most important expenses, the “needs” over a one month period. This usually includes your rent or mortgage payment, utilities, food and transportation. An emergency fund ideally has enough cash to cover three to six months of the most-needed expenses.
You may want to add to this account to fund an unexpected medical or family need. Consider holding enough cash to cover your medical insurance deductible. Getting through a medical need, and knowing you are ready for the unexpected, can make a difference in your outlook and your health!
If you are already retired, there is no threat of job loss. However, cash is needed for unexpected expenses and maintaining your standard of living without having to sell long-term investments. If you have pension, social security or rental income, then less cash is needed.
As you build your emergency fund or additional cash reserves, where do you maintain the cash? Keeping large amounts of cash in your home is not advised. Maintaining a large balance in your checking account leaves the funds in a space where they can be spent easily. If that is an issue for you, move the funds to a savings account, where it could take a day or two to access the funds. Cash should be held in a savings account at a bank, credit union or brokerage firm.
Once your emergency fund is set-up, are there other needs for cash or can you invest the rest? The right amount of cash varies by the kind of work you do, how many people you support, your stage in life and your feelings about cash. Is your job a secure job? Is your place of employment experiencing any signs of distress?
If you are self-employed or working as an independent contractor, work disruptions can be more common. In a recent Christine Benz article on Morningstar.com, she states “if a self-employed person is forced to turn to unattractive forms of financing such as credit cards to defray near-term income needs, the cost of that financing is likely to swamp the long-term returns on any money earmarked for retirement. Ditto for having to raid retirement assets like IRAs prematurely, as doing so usually carries taxes and a penalty.” So, for your emergency fund, perhaps aim for the high end of the three to six months of living expenses.
Besides emergencies, some people like to hold more cash for other goals, like home down-payments, new cars, car repairs, vacations or even investment opportunities. Each of us can think about where we need cash. Giving it a little thought may bring you peace.