Cash Reserves

Cash Reserves

A cash reserve is a pool of funds (and sometimes credit) that you hold in a readily available form to meet emergency and other highly urgent, short-term needs. Sometimes, it is referred to as an emergency or contingency fund. A sound financial plan should ensure that you are protected when financial emergencies arise. In times of crisis, you do not want to shake pennies out of a piggy bank. Consequently, the first step in the financial planning process should be to establish a cash reserve.

The amount of your cash reserve should be based on your own personal situation. While basic guidelines do exist, you should adjust them to reflect your unique circumstances. You must take into account such factors as job security, the condition of your real estate, and the health of you and your dependents when determining the ideal size for your cash reserve. For more information, see What Factors Should Be Considered When Determining a Cash Reserve Goal? Naturally, such factors change with time, so an annual review and adjustments are important elements of the planning process.

How much do you need?

Your cash reserve should generally equal 3 to 6 months of ordinary living expenses. Occasionally, low job security or high income volatility might suggest having a reserve of up to 12 months of expenses. The actual number of months selected should reflect these and other significant risk factors, such as the adequacy of insurance coverage and the condition of any property you own.

Using Credit is an Option

The amount of credit available to you can be a secondary source of funds in a time of crisis. However, because borrowed money must be paid back (often at very high interest rates), do not use lenders as the primary source of your cash reserve. When a crisis produces an urgent financial need, you can still repay borrowed money, making credit a viable option in a multi-tier cash reserve structure.

Taking stock of what you have

List the locations and amounts of your money that you can withdraw on an immediate (or nearly immediate) basis without incurring a loss and tally the result. Typical sources include savings accounts, money market accounts, Treasury securities, and cash value life insurance. Be careful to exclude accounts set up to meet everyday needs or special objectives, such as education, vacations, or a new car. You can also include untapped credit resources, provided you count them separately from cash resources.

This is almost as easy as subtracting what you have from what you need. If you elect to consider credit resources part of your cash reserve, the procedure is slightly more complex, since part of the total amount must be held as cash (noncredit) assets.