Personal Finance Essentials
Recommended Cash Reserve Levels
How Much “Sleep Well at Night” Money
Do You Actually Need?
Financial advisors recommend that you maintain a minimum of 3 months’ worth of living expenses in cash reserves. Many recommend as much as 24 months of reserves, on the basis that those who experience job losses or health issues can suffer extended periods of adverse financial impacts.
The amount you need depends on two factors: how much you spend each month and the stability of your income. Focus first on your monthly expenses – not your income. Add up all the costs you cannot avoid no matter what: housing, food, utilities, insurance and loan payments. That total is your baseline.
How to Calculate Your Monthly Expenses
The easy approach is to look at your bank and credit card statements, but that method may not capture the full picture. Credit card charges and sporadic expenses – such as annual insurance premiums or quarterly tax payments – can fall through the cracks. A more reliable method is to review your bank and credit card statements for the past six months, and exclude any one-time or non-recurring expenses. That gives you an accurate average of your true monthly spending. Once you know your monthly expenses, multiply by the appropriate number of months to determine your target reserve level.
Income Stability and Your Reserve Target
The stability of your income determines how large your reserves should be. If you and your spouse both have highly secure jobs, or if your income comes from a government pension, a smaller reserve may be adequate. A married couple with two stable incomes might find two to three months of reserves sufficient. On the other end of the spectrum, a self-employed individual or someone whose income depends on a single employer should aim for at least 12 months – and 24 months is even better.
It is equally important that you maintain only enough in reserves – not more. The interest rate your reserves earn is very low, lower than virtually any other type of investment. Every dollar you park in cash reserves beyond what you need is a dollar that is not working hard enough for your future.
If You Own Rental Property
If you own rental property, your cash reserve needs are larger than most. In addition to your personal reserves, you should maintain at least 12 months’ worth of the rental property’s carrying costs – mortgage payments, taxes, insurance and maintenance – set aside specifically for that property.
The reason is straightforward: tenants can stop paying rent, and the legal process is slow and expensive. In a worst-case scenario, a tenant can stop paying, file for bankruptcy to delay eviction and ultimately leave the property damaged – all over the course of a year or more. Without dedicated reserves for that property, those costs come directly out of your personal finances. This is true for every rental property you own, so add 12 months of carrying costs per property to your total reserve target.