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How Much Cash Reserve Should I Have?

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How Much Cash Reserve Should I Have?

The typical American family has liquid cash in personal savings of only $4,807 (US Debt Clock, US Congressional Budget Office, 2018). According to a 2015 survey, 69% of Americans had less than $1,000 in a savings account. As a result, many will be in financial hot water in the case of a family emergency, such as a major car or home repair, lasting disability or interruption in employment.

Families with strong liquidity ratios can avoid such troubles. A liquidity ratio is defined as the number of months that an individual or family could continue to meet basic household expenses by accessing available cash assets (such as savings, money market funds, checking accounts, etc.). The ratio is calculated by dividing cash assets by monthly expenses. For example, if an individual has $10,000 in cash assets and $2,500 in basic household expenses, his liquidity ratio is 4. A standard recommendation is to have at least a 6 ratio – the higher the better, as this means more months of expenses can be paid by reserves.

There are significant advantages to having access to cash when you need it:

  1. More likelihood that payment obligations can be made timely, which prevents extra interest, late fees and charges.
  2. Credit scores will generally improve when cash reserves are present as the family is no longer living paycheck to paycheck. Credit scores impact the cost of insurance, loan rates, employment opportunities, etc. Improving your credit score is a very significant money saving strategy.
  3. You will be positioned to possibly take advantage of an opportunity when it presents itself, as you may have access to cash where a competitor does not.
  4. You will experience better negotiating opportunities. Whether you are purchasing or negotiating a contract, having cash means you will not necessarily be subject to financing contingencies for example. You may ultimately choose to finance the purchase but approaching a seller with the ability to pay cash can enhance your ability to negotiate the price and/or terms in your favor.
  5. Peace of mind comes from the security of a cash reserve enough to handle projected essential expenses for several months. A job interruption or major expense would not be as devastating as it once was. Removing financial stress can help with health issues such as depression.

It is a new year, and it may be the perfect time to begin improving your liquidity ratio. Here are a few tips on how to do that:

  1. Create a budget.
  2. Stick to the budget – surround yourself with like-minded people and talk about your financial goals.
  3. Pay yourself first. Your new plan is your priority.
  4. Use the right type of account for your savings. Retirement plans such as 401(k)s and IRA(s) are not liquid for the purpose of calculating your liquidity ratio, as these plans have limits, income tax consequences and possible penalties if accessed.
  5. Be detailed in your plan. Include the amounts and the timing of planned deposits.
  6. Make your goals reasonable.
  7. Check your progress monthly. It is ok if you have a bad month – knowing where you are at will help get you back on track.
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