An integral component of a financial plan is making sure that you have adequate cash reserves set aside. But exactly how much is enough?
Cash in the bank has several purposes: (1) to fund living expenses; (2) to fund short-term planned expenses (upcoming trips, home improvements, new car, etc.); and (3) to fund unanticipated expenses. While there are no clear-cut rules as to how much should be set aside, below are some things to consider.
Living Expenses – Most people have some form of income that they use to cover their living expenses – this may include income from work, pensions, and social security. The reliability and adequacy of this income need to be considered. If your job is stable, or if you are confident that if you lost your job, you could quickly find another, perhaps you only want to set aside a few months (3-6 months) of your cash needs, but if you have concern about the likelihood of losing and replacing this income, you will want to set aside more cash, just in case. Consideration should also be given to how dependent you and your family are on your income. If you are married and both you and your spouse individually make enough to support your family, the likelihood of you both losing your job at the same time is slim – this would suggest less would need to be set aside. But if you are the sole wage-earner and you and your family are completely dependent on your income, you would want to set more aside.
Short-Term Planned Expenses – You will want to think ahead about upcoming large expenses, be it a trip, a new car or even a home improvement, and set funds aside so that you have the cash available when you need it.
Unanticipated Expenses – Life always throws us curveballs and it is critical to be as prepared as possible from a financial standpoint. The best way to do that is to set some cash aside for whatever may come your way. If you live in a new home, you probably don’t need to set aside as much as you would if you live in an older one. If you have a family with young children, you probably need to set aside more than if you were a retired couple. There is no specific parameter as to how much to set aside for emergencies, but this is your “peace of mind” money – the money that enables you to sleep at night. For some, that is a few thousand dollars, for others it may be tens of thousands.
Funds that you set aside in the bank are not expected to earn anything – that is not their purpose. Their purpose is to provide you with peace of mind that no matter what life throws your way, you will have adequate liquidity to meet your needs.
