If you want to make smarter financial decisions, you cannot ignore the emergency fund on your balance sheet.
However, since emergency funds (or cash reserves) provide no return and have pitifully low interest rates, it’s more tempting than ever to forego a cash reserve account. A look at the current interest rates seems to support the “use it or lose it” argument.
The savings account at a local credit union currently has a dividend rate of 0.10%. So for $100,000 one would earn $100 interest for an entire year. Money Market accounts and Certificates of Deposits aren’t much better. Per bankrate.com, the daily overnight average rate for a one-year C.D. is 0.81%. That provides a whopping $810 annually on a $100,000.
Armed with these sad facts, logic argues, “Isn’t it wiser to pay down debt? Or to invest it (in anything)? Or to spend it since it isn’t growing?”
It’s easier than ever to ignore the need for a typical emergency fund. In fact, holding these do-nothing funds makes us uncomfortable. And none of us like to feel uncomfortable, do we?
Man Plans, God Laughs
There will always be unexpected turns, both good and bad, in our lives. None of us can plan for the unexpected. The real return from keeping adequate cash reserves is that it provides us the flexibility to make smarter financial decisions.
First, it gives us the flexibility to absorb unexpected expenses easily. If we incur a major expense without cash on hand our options are limited:
1) We sacrifice our current lifestyle while saving to cover the expense.
2) We sacrifice our future lifestyle by going into dept.
3) We sacrifice profit by selling assets as a motivated seller.
4) We sacrifice our comfort by not covering the expense.
None of these are attractive options. Having cash reserves in an emergency fund will give us the flexibility to simply pay the expense or choose an option that’s best for us.
Second, it gives us the flexibility to seize the day as opportunities arise:
1) We maintain our lifestyle while covering unexpected expenses.
2) We benefit our future lifestyle by protecting our savings.
3) We increase our bottom line by buying from motivated sellers.
4) We have the liquidity to seize the opportunity for the best deals.
How Much Should We Keep?
There is no rule for the appropriate amount of cash reserves we should keep. Keep too much and we incur the cost of alternative uses like investing or paying down debt. Keep too little and we limit our options when the unexpected arises. Here a few thoughts on getting it just right for you.
First, start with three months of lifestyle expenses as a baseline. Then look at the stability of your income. If you have predictable income and your job security is strong, you may stick with three months reserve. As the uncertainty of your income and employment increase so should your reserves. It is not unusual for someone with a highly volatile income to have over a year’s worth of cash reserves.
Have a question about how to create an emergency fund that’s suitable for you? Ask me below or Tweet to @roger_whitney