Everyone says that you have some money set for a rainy day but rarely do they expand past that statement. Let’s talk about how you create a cash reserve strategy to help your money work as hard as you do.
Your cash reserve is the money that you have set aside for emergencies. An emergency is not a sale at your favorite store or a new driver to improve your golf game. An emergency is the loss of a job or an income earner becoming disabled and not being able to continue working. Most professionals will recommend that you have three to six months of living expenses in reserves. This amount includes your rent/mortgage, car payments, insurances, groceries and all other expenses that your household requires to operate on a monthly basis. Once this amount is decided, the question becomes where should I put these reserves. Holding large sums of money in a checking account can be dangerous because it is easily accessible thus can be easily spent on those non-emergency emergencies. A three-tier cash reserve allows you access to the money but it also allows you to earn a slightly higher interest rate on a portion of the funds as your account grows.
Your first tier can be your checking account. If you are a disciplined spender/saver, you can save one month of your household expenses in your checking account. In the event of an emergency, the money is readily available and there are no transfers required to take care of your obligation. However, if you are not disciplined, consider opening a separate checking account at a different bank or credit union so that you still have the ease of access during an emergency but not the temptation to spend the money frivolously.
The second tier is generally a savings account. You should maintain one to two months of living expenses in this account. Savings accounts normally provide a higher interest rate than your checking account therefore your money is working for you rather than sitting idle. You can attach your savings and checking accounts if you are disciplined, however, if you are not, you should ask your banker to separate the accounts so that the funds can not be accessed through your ATM. This account should only be accessed if your emergency is dire and you have exhausted the funds in your first tier.
The third tier can be held in a money market savings account or certificates of deposit (CDs). These accounts often have a penalty for frequent withdrawals because the bank expects you to invest the money and leave it with them for an extended period so that they can use it for loans. This is why they are able to pay a higher interest rate. Two to three months of expenses should be held in this tier and should be considered a long-term investment. Obviously, these funds should only be accessed once you have used the monies in the first and second tiers.
Although the financial market can seem scary right now, you have to be disciplined and consider your cash reserve strategy as a part of your overall investment strategy. Cash reserves, unlike stocks and mutual funds, are FDIC insured when held at a bank. Your money matters, have discipline, make smart decisions and you can weather any financial storm.
The danger of not having a cash reserve is that when you encounter an emergency you are often forced to use a credit card or apply for a high interest loan. Either of these options will increase your debit load. Some people say that they can’t save because they have to pay off their debt. I say that you have to do both even if you are just saving a little bit.
Consider this…you have paid off all your debts but saved no money, an emergency occurs, what do you do? Go back into debt because you have no cash reserve to bail you out…