Establishing or Increasing a Cash Reserve
What is the cash reserve building process?
Building a cash reserve is the process of actually setting up and funding the account(s) that will compose it. When available funds fall short of the cash reserve goal, the first step is to review alternatives for reaching that goal. Knowing these alternatives, you can then develop a plan based on the desirability of the various options. A multifaceted approach is advisable given the importance of quickly achieving adequate financial protection.
Evaluate alternative ways to achieving a vital goal
Each approach to funding a cash reserve has inherent advantages and disadvantages that need to be weighed before incorporating them into a plan. Below are several common options.
Use a systematic savings plan
Systematic savings is the approach of first choice because nearly everyone can save more on a regular basis than they presently do. Upon achieving your cash reserve goal, you can redirect savings toward other objectives such as education, vacations, and retirement. You can save systematically by budgeting a periodic self-payment of a designated monthly or weekly amount by automating account transfers or by using payroll deduction. Most financial institutions and many employers offer payroll deduction.
Arrange with your employer, bank, or other financial institution for the automatic withholding or transfer of the amounts designated in your plan. If one or more separate cash reserve accounts are part of the plan, set them up as soon as the funds are available. Doing so will provide a place to which you can transfer designated and accumulated savings.
Reposition some current assets
By definition, current assets are the things you own either in the form of cash or in a form that can readily be converted to cash. This broad definition includes nearly everything that can be sold easily and quickly. Current assets range from investments such as stocks and bonds to a vacation savings account, and may include funds that could be redesignated as part of a cash reserve or moved into a special cash reserve account. Designating money or credit for a cash reserve means that you recognize its special function even if it is not isolated in a special cash reserve account. Repositioning current assets may involve selling or redeeming assets that are no longer needed or that have lost any special meaning and adding the proceeds to the cash reserve.
If current assets are being used to build your cash reserve, add these to the plan first. When using noncash assets for which the actual value cannot be determined before their sale or conversion, use a conservative estimate of value.
Caution: Beware that some types of accounts require advance notice for withdrawal of significant amounts or impose an early withdrawal penalty.
Reallocate maturing term deposits
Term deposits, such as certificates of deposit (CDs), are savings vehicles that require funds to be deposited for a set period of time (early withdrawals are generally subject to harsh penalties). If you have CDs coming due soon, you can add proceeds to a cash reserve. If your cash reserve structure includes CDs, they should be part of a multi-tier cash reserve structure and you should consider laddering the maturity dates. Similarly, other types of term deposits or bonds that may be approaching maturity might offer another source for cash reserve funds.
Use earnings from current investments
If you have earnings from other investments, or income-producing property, you could redirect those earnings toward your cash reserve instead of reinvesting them. When your target level has been achieved, you can again use these funds for portfolio building or other purposes.
Caution: Tax-sheltered earnings should remain tax sheltered. Consequently, they are inappropriate for building a cash reserve.
Reduce discretionary spending
Reduction of spending through budgeting and a spending plan need not be as painful as it sounds. Good spending habits improve financial health just as good eating habits affect personal well-being. It can be helpful to think of this process as repairing a crack in the foundation of your financial house. You can begin reducing discretionary spending by tracking how much you currently spend. Then, you can decide by what amount or percent you need to reduce that amount in order to save.
Reducing discretionary spending can be done in a variety of ways, some of which are easier than others. Areas that many people tackle first include entertainment, dining out, pocket or spending money, lunches and snacks at work, costly vacations, clothes, and extravagant gifts. The operative word is reduce, not eliminate.
Use lump-sum income instead of splurging
The most common types of lump-sum income are tax refunds and bonuses. Other types of windfalls include gift money, inheritances, and various kinds of winnings. Some, like tax refunds and bonuses, can be anticipated, but others come by surprise. Whatever their source, they are an excellent aid to building a cash reserve. If the temptation to splurge is too strong to ignore, consider splurging a bit less and diverting a portion of the money into your cash reserve.
Commit now to allocating lump sums you expect to receive within the next several months to your cash reserve. This helps prevent you from dreaming about other uses for it.
Avoid temptation. When that tax refund arrives or your sweepstakes ship comes in, add whatever money is necessary to your cash reserve before fulfilling other needs or splurging.
Launch your plan as soon as possible and monitor its progress
Begin to implement your cash reserve building plan immediately. The sooner your cash reserve is fully funded, the sooner you’ll have peace of mind and be able to turn to other financial pursuits such as building your portfolio, saving for a new home, or pursuing a degree that you have always wanted.
Caution: Be aggressive in building a cash reserve, but not so aggressive that you find yourself constantly digressing from it. Few can adhere to an overly severe plan of any kind for very long.
Track progress monthly to see whether your progress is significantly behind or ahead of the plan. If so, you may need to make adjustments. If you’re falling short on your plan, you may need to further adjust spending and saving levels. You also might add a savings approach you may have previously excluded as unnecessary. When you’re ahead in your game plan, you have the flexibility to decide whether to reach your goal sooner or rethink your savings level.
Consider the structure of your cash reserve
The structure of a cash reserve refers to the types of accounts in which the reserve is held and how the funds are apportioned among those accounts. Funds in a cash reserve should be readily accessible, but this does not mean that basic savings accounts are your sole option. You may find other account types that pay higher interest in exchange for less accessibility and little if any increased risk. Credit, too, can be included in a cash reserve, provided that it will not be inadvertently used for other purposes or withdrawn by the issuer.
Maintaining a cash reserve is the process of reviewing it periodically (usually annually) and adjusting it to fit any significant changes in your financial circumstances, lifestyle, spending, or income.
Consider accessibility versus interest rate when deciding where to hold cash reserve funds
Accessibility to cash reserve money should be the primary consideration when choosing the account type(s)in which to keep your funds. Immediate access to part of the cash reserve, without incurring a penalty, is imperative. In the case of larger cash reserves (for example, the equivalent of four or more months of expenses), you might consider placing part of the money in accounts that offer higher interest rates.
Review pros and cons of alternative account types for structuring a cash reserve
Here are the basic categories of accounts that are suitable for holding cash reserve funds:
|Account Type||Funds Access||Pros||Cons|
|Ordinary savings||Immediate||Instant accessCan save on fees Insured by the Federal Deposit Insurance Corporation (FDIC) up to $250,000*||Very low interest rates|
|Money market deposit accounts**||Immediate (except minimum balance)||May have potential for better interest rates FDIC insured up to $250,000||Usually requires minimum balance to avoid penalty|
|Certificates of deposit (CDs) & other term deposits||Limited to term of the certificate||May have potential for better interest rates Terms vary FDIC insured up to $250,000||Penalty for premature withdrawal|
|Money market mutual fund||Immediate if by check (except minimum balance)||May have potential for better interest rates Limited access by checks often available||Usually requires minimum balance to avoid penalty|
*Funds held in different types of ownership (individual, joint, trust, retirement) are separately insured.
Caution: **Don’t confuse a money market deposit account with a money market mutual fund. An investment in a money market mutual fund is not insured or guaranteed by the FDIC or any other government agency. Although the mutual fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in the fund.
Caution: When considering a money market mutual fund, be sure to obtain and read the fund’s prospectus, which is available from the fund and outlines the fund’s investment objectives, risks, fees, expenses. Carefully consider those factors before investing.
Using credit as part of cash reserve plan needs careful consideration
If you’ve been careful about debt management and establishing credit, you may be able to use credit as a source of emergency funds. The need to repay borrowed money, often with extremely high interest charges, makes this a less desirable option than having a cash reserve that doesn’t include, for example, a bank line of credit or consumer debt. Still, you can use credit as a backup source of funds for financial crises that do not diminish income.
Example(s): Frank’s elderly mother, Martha, now living with Frank and his family, recently fell and is confined to a wheelchair. Consequently, Frank wants to modify his home to accommodate her. Rather than deplete his cash reserve, he will obtain a home equity loan since his income will enable him to repay it quickly without incurring high interest charges.
Establish lines of credit before the need arises
Credit lines take time to establish, and require completing an application that lists current credit sources, outstanding balances, references, and the amount of credit being requested. The lender must then verify, review, and approve or deny the application. Consequently, credit lines need to be established well in advance of when they will be needed. More importantly, you may find it almost impossible to obtain credit when you are experiencing financial trouble.
Interest rates vary, so shop for the best deal
A home that has been owned for a few years or more sometimes can be used to obtain home equity financing. Home equity financing (which can be structured as either a loan or a line of credit) uses the equity in your home to secure a loan. As a result, home equity financing may offer a more favorable interest rate than those offered on an unsecured, personal loan.
Cash value life insurance, in cases when it is desirable to own it, can also be a source of low-interest credit. Insurers commonly allow policyholders to borrow a portion of their cash value provided they later repay it. If loans are not repaid, insurance proceeds at death are reduced by the amount of the outstanding loan balance.
Caution: Borrowing against the cash value of a life insurance policy can affect the terms and amount of coverage. Carefully review the policy’s conditions on borrowing and, if unacceptable, exclude this alternative from your cash reserve plan.
Lending institutions such as savings and commercial banks, savings and loans, and credit unions are potential sources of credit.
Credit cards are an expensive alternative
High interest rates make credit cards an expensive alternative, especially since financial crises often require significant sums of money that can rapidly increase your total debt burden. However, depending on your existing debt and whether you have additional sources of emergency cash, they also can be counted as part of your financial cushion.
Building a multi-tier cash reserve structure
When the amount of your cash reserve exceeds three to four months of ordinary living expenses, you might consider creating a multi-tier cash reserve structure. Using this approach, you may be able to earn higher rates and, if desired, incorporate credit as part of the cash reserve.
Ladder maturity dates of term deposits for better accessibility
Laddering refers to the purchase of term deposits, such as certificates of deposit and Treasury bills, so that they will mature at different times throughout a given time period.
Maintain the cash reserve through periodic review and adjustment to meet changing needs
Numerous events occur during your life and the lives of your family members that influence your cash reserve needs. Reviewing those needs periodically and following through with appropriate adjustments helps assure that your cash reserve fits your current needs. It also avoids unnecessarily holding funds that can be more productively used elsewhere.
Review cash reserve needs annually
A yearly review of your financial circumstances will generally reveal any significant changes in your cash reserve needs. For example, marriage, a new child, the loss of a loved one, or a significant income change can signal the need for an increase or decrease in your cash reserve.
Caution: Changes in job stability are a key consideration here. Impending cutbacks by your employer, or taking a new position where your skills and compatibility are yet to be tested, reduce job stability. That new job can bring not only a new income level, but also greater income volatility. Changing factors like these may suggest reducing or expanding your total cash reserve.
Adjust cash reserve amount and account structure as appropriate
If you decide to change the size of your cash reserve and it has a multi-tier structure, think about how the addition or removal of funds will change the existing structure. Generally, you can expand an established cash reserve that uses a multi-tiered approach by adding a new tier or increasing an existing one. If you decide to deliberately shrink your cash reserve, consider reducing or eliminating any tier except the first, which consists of the most readily available cash to be used as your first line of defense in time of need.