I often get this question from my clients: How much cash should I have available in my bank accounts? The idea is that this cash should be used as cash reserves if a major, unexpected expense happens. Specifically, think about what it could cost of your car’s transmission died, or if you needed to replace a furnace in your home. Or even worse, do you know how long you could live off your cash savings if you were to lose your job today and have to search for a new one?
The general “rule of thumb” is to maintain 3-6 months of expenses in a cash reserves position— the idea that this amount could cover some of the previously mentioned major expenses, as well as provide a cushion in the event that you or a spouse is out of work for a few months.
- Do you know how much it costs to run your life?
This is why having a budget is so important—it’s at the root of every single piece of financial advice you’ll ever receive. Even if you don’t feel like you need to follow a budget, it’s critical that you have a good handle on what it costs to run your life on an average month. For example, a couple who spends around $5,000/month should hold somewhere between $15,000 - $30,000 in cash reserves. Anything above $30,000 should be allocated to the investment portfolio.
- I’m saving for a down payment on a home within the next year, what should I do with the cash?
Although there are varying schools of thought on this question, I will always lean towards recommending my clients hold anything in cash that they expect to spend within the next 12 months. So, if you need to have $60,000 saved up as a down payment on a home that you’d like to purchase within the year, I would recommend holding that aside in cash in addition to your existing cash reserves.
- Is it a bad idea to hold TOO MUCH cash?
The short answer is yes, but this is obviously a good problem to have. Many of you have heard the financial guru (who shall remain nameless) who talks about how buying a $4 cup of coffee once per week will cost you millions of dollars by the time you retire. This concept works the same for holding too much in cash, so think through the following example:
I have 6 months of expenses saved up, plus an additional $50,000 (because I like the security of holding the extra cash). If I were to invest this cash and earn an 8%/year return, this would become just over $500,000 in 30 years. To the contrary, if I earn 1%/year sitting in my savings account, this would only be a measly $67,000 30 years later.