Cash Reserve
A cash reserve is a pool of funds (and sometimes credit) that you hold in a readily available form to meet emergency and other highly urgent, short-term needs. Sometimes, it is referred to as an emergency or contingency fund.
Caution: Terminology is important here because contingencies often are not emergencies. Purchasing an expensive item that suddenly goes on sale or buying stock when its price suddenly drops might lead one to tap a so-called contingency fund, but these are certainly not emergencies.
The definition used here of a cash reserve is money set aside solely to cover critical, unexpected needs, such as a sudden loss of income. Consequently, it is not a fund for meeting anticipated expenses, large or small, such as real estate taxes, tuition or a spontaneous vacation. Instead, a cash reserve protects you, your family and your loved ones against unexpected financial crises.
Example(s): The manufacturer of a new computer you've been thinking about buying has just announced a substantial rebate on machines purchased within the next two months. While this might be an excellent opportunity to purchase the item at a reduced cost, it is not an emergency and therefore does not justify tapping your cash reserve. Maintaining sufficient savings elsewhere eliminates the temptation to tap emergency-designated funds for non-emergency needs.
Why is a cash reserve necessary?
A sound financial plan should ensure that you are protected when financial emergencies arise. In times of crisis, you do not want to shake pennies out of a piggy bank. Also, having a cash reserve may help prevent being forced to take on additional debt precisely when another financial challenge is the last thing you need. Consequently, the first step in the financial planning process should be to establish a cash reserve.
Determining how large a cash reserve should be
The amount of your cash reserve should be based on your own personal situation. While basic guidelines do exist, you should adjust them to reflect your unique circumstances. Some of the factors to be considered when determining a cash reserve goal include job security, the condition of your real estate and the health of you and your dependents. Naturally, such factors change with time, so an annual review and adjustments are important elements of the planning process.
Three to six months of routine living expenses compose a typical cash reserve, but there are exceptions.
You should generally follow the three to six months rule; that is, your cash reserve should equal three to six months of ordinary living expenses. Occasionally, low job security or high volatility in income might suggest having a reserve of up to 12 months of expenses. The actual number of months selected should reflect these and other significant risk factors, such as the adequacy of insurance coverage and the condition of any property you own.
Taking stock of what you have
List the locations and amounts of your money that you can withdraw on an immediate (or nearly immediate) basis without incurring a loss. Typical sources include savings accounts, money market accounts, Treasury securities and cash value life insurance. Be careful to exclude accounts set up to meet everyday needs or special objectives, such as education, vacations or a new car. You also can include untapped credit resources, provided you count them separately from cash resources.
Review and adjust your cash reserve annually to reflect your changing circumstances
If anything is certain, it is that the personal and financial circumstances of you, your family and your loved ones are very likely to change within the span of a year or two. A new child comes along, an aging parent becomes more dependent, a larger home or new car brings increased expenses or maturing offspring leave the nest. Because your cash reserve is your first line of protection in a financial crisis, it is important to review it annually. If the amount and structure of your reserve no longer matches current needs, you should make the appropriate adjustments. An overly large reserve can mean that opportunities for better returns are being overlooked. In contrast, an undersized reserve increases the risk for financial chaos and stress in a time of sudden need.
Related Links: