Most people realize that they should put aside enough cash to protect themselves against an emergency or a sudden loss of income. If the unexpected happens and an adequate cash reserve is not readily available, you may be forced to sell investments or real estate for less than they might be worth at another time under less pressing circumstances.
That’s why it’s wise to plan your emergency cash needs carefully. Here’s how to go about it.
How Much Cash is Enough
Step 1: Estimate your living expenses. It’s fairly simple to estimate your annual living expenses, but be careful not to forget anything. Rent or mortgage payments, food, clothing, car maintenance, utilities, and monthly debt payments are seldom overlooked, but people tend to forget insurance premiums (car, life, medical, homeowner’s, etc.) and payments which are made quarterly or semi-annually.
To determine how long your cash reserves should last, a good rule-of-thumb is to set aside enough cash to pay your expenses for six months if your household has only one wage-earner. If your household has two wage-earners, a three month cash reserve is adequate in most cases.
Modify these time periods by considering how long it might take you to find new employment if you lost your present job, and how long it would take your disability insurance to take effect if you couldn’t work because of illness or injury.
When you calculate how much cash you’ll need, don’t count on certain kinds of income to provide that cash. For example, you might be tempted to include anticipated dividends from equity investments as part of your cash reserves. That’s a mistake because income from stocks is not guaranteed.
Step 2: Establish your inner comfort level. Everyone is different and you should consider whether you’ll really feel secure that your cash reserve is adequate. If you’re uncomfortable about only having enough money to meet expenses, then put aside a specific amount beyond and above those expenses.
Keep in mind that your needs will vary depending on your circumstances. For example:
- If there’s a new baby in your family, you should increase your emergency cash level.
- If you are young, single, and without debt, you may not need to maintain a high level of cash – particularly if you have skills that make you easily employable.
- If you are about to retire, chances are that you’ll feel insecure in what will be an entirely new way of life. A cash reserve that’s well above regular expenses may be called for, at least until you feel comfortable about living as a retiree.
- If you’ve started a new business, don’t count on it to produce immediate personal income. Instead, increase your emergency cash until you’re certain that the business will generate a steady income. In some cases, this can take a few years.
Put Your Cash in the Right Place
Security and liquidity are the major criteria for where to keep your cash reserves. Put your money where it will be readily available to you when you need it. The two most common choices are:
- A savings account. You’ll earn a low interest rate, but if you’re very conservative you’ll know your money is completely safe.
- A money market fund. Bank money market funds are federally insured, but other money market funds earn a higher interest rate and are usually quite safe. Look for funds that have check-writing or telephone withdrawal privileges.
Wherever you put your emergency cash, make sure it earns compound interest. It’s possible that you may never have to use your cash reserves and over a period of time, the power of compound interest can build a tidy nest egg for you.