With a hot stock market, it’s hard to think about keeping much of your money in low-yield savings vehicles, but building an emergency cash fund should be a top priority. How much of a reserve should you have and where should you keep it?
Most financial planners suggest that you keep a cash reserve of at least 6 months of basic living expenses. This should allow you to survive any catastrophic events like the loss of a job or business as well as lost income due to major illness and other unforeseen emergencies.
At a minimum, your cash reserve should be sufficient to cover:
- Your rent or mortgage payment (including insurance and taxes)
- Utilities on your home
- Minimum payments on credit cards
- Any debt payments for automobiles and other consumer debt
- Insurance costs
- If you are a sole proprietor, the fixed costs of maintaining your business until you can get back to work (not needed if you have business interruption insurance)
Your emergency savings should be kept in short-term highly liquid accounts. Appropriate accounts to hold your emergency savings are money market accounts, bank savings accounts, short-term certificates of deposit and bank checking accounts. Where you choose to put your money will depend on the level of risk you are willing to take, but remember: the lower the risk, the lower the return.
If you are looking for low risk accounts to hold your emergency reserve, bank accounts that are insured by the FDIC are the safest. Bank checking accounts provide you with the fastest access to your cash, but offer extremely low interest rates. Bank savings accounts are almost as easy to access as a checking account and usually offer slightly higher returns. If you want to go with a bank product, your best bet is to purchase certificates of deposit. These accounts are FDIC insured and provide the highest interest rate, but they are also the most illiquid. Should you choose to purchase CDs, you will want to ladder them to provide access to your funds when needed. We will discuss this a little later.
Money market accounts offer you the fastest access to your cash with a relatively decent return on your money. Typically, you can write a check to pay a bill out of your money market or transfer the funds to your checking account. Money market accounts, however, are not FDIC insured accounts, so they are a little riskier. The level of risk, though, is not high because money market funds are invested in very short-term high quality debt instruments. Market downturns generally will affect the interest earned on money market accounts, but not the principal balance. Because the funds in a money market account are readily accessible, the interest you earn on them is lower than what you can get for a certificate of deposit, but greater than other bank products.
To maximize the interest you earn on your “rainy day” funds, you can invest in certificates of deposit and ‘ladder’ the maturities. For example, let’s say your reserve should be $42,000. You can ladder your rainy day fund by keeping some of the funds in a money market account for your first month’s expenses. Generally, this would be 1/6 of the total or $7,000. You would then invest in certificates of deposit that mature in increments of 30 days as follows:
- $7,000 in 30 days
- $7,000 in 60 days
- $7,000 in 90 days
- $7,000 in 120 days
- $7,000 in 150 days
This will provide you the cash you need without costing you early redemption penalties.
Life has a way of throwing us a few curve balls. While investing in the stock market is potentially more rewarding, keeping a cash reserve for emergencies is essential. Give us a call if you have any questions on how to set up and fund an emergency reserve and how much you should maintain. We are here to help you in any way we can.
Have a terrific June.