Emergency Fund

Establishing and maintaining a budget is an essential part of achieving your long-term financial goals and obtaining financial freedom. One tool that makes budgeting extremely convenient is a budgeting application (app). Being able to immediately input transactions from your phone at any time or location makes budgeting easy.

How much cash do I need?

While there is no set number that each of us needs to save and keep in cash, the answer really depends on your spending habits. If you have higher monthly payments (e.g. mortgage, rent, health insurance, etc.), then you need more cash. In contrast, if you live in an area with a very low cost of living, the emergency fund can be smaller. The general rule of thumb is to save three months of living expenses as your emergency fund. If you want to find out how to determine what three months of expenses is for you, I encourage you to take a look at our “How to Create a Budget” and “Best Budget App” articles. These tools will help you calculate, track, and manage your monthly expenses.

While three months may seem like a reasonable amount, I know this can be extremely difficult to do, especially if you are working to pay off debt. If you have a lot of credit card or other high-interest debt, start with a one month emergency fund. Once you reach this amount in savings, focus on paying off debt. Pay off those cards with the highest interest rate first. As soon as you can pay them all off, you will be surprised how much more freedom you have. Rather than paying the creditors, you can start using that money to pay yourself. It may be tempting to skip the emergency fund if you have a lot of debt and focus on paying that off, but doing so may cause a yoyo pattern because each time an emergency arises, you will utilize a credit card to pay for it, which in turn increases your debt.

How much of my net worth should be in cash?

Let’s jump forward. You have already paid off all your debts and saved three months of emergency funds. Now you may be wondering how much of money to keep in cash. This amount will be based on your net worth. To calculate your net worth, add up all your assets and subtract any liabilities. Assets are items of value (property, car, savings accounts, stock, bonds, etc.). In contrast, liabilities are obligations you must pay (credit card debt, mortgage, car loan, student loans, etc.) For example, if you have a $300,000 home with a remaining mortgage of $200,000, a $20,000 car, $10,000 in savings, $10,000 in student loans, and $30,000 in a retirement account, then you would add all the assets and subtract the liabilities. In this case, your assets would be $300,000 (house) + $20,000 (car) + $10,000 (savings) + $30,000 (retirement account) = $360,000. Similarly, your liabilities would be $200,000 (mortgage) + $10,000 (student loans) = $210,000. Now that you have calculated both assets and liabilities, simply subtract the liabilities from assets. In this example, $360,000 minus $210,000 leaves a net worth of $150,000.

You now know how to calculate net worth, but that does not answer your original question: how much cash do I need? Don’t worry, that whole exercise was not for nothing. Your net worth will tell you how much to keep in cash. My recommendation is at least 10%. Depending on the economic environment, it may well be worth keeping more in cash. For example, if an investment you are wanting to purchase is over priced at the moment, then holding more cash to take advantage of a favorable price drop makes sense. Some of the best value investors exercise extreme patience, holding large sums of cash until the right opportunity presents itself. Additionally, if you know of a large upcoming expense, such as a wedding or move across the country to start a new job, you may want to increase your cash reserves.

Conclusion

We all need an emergency fund. It is best to save at least three months of expenses. This gives you flexibility if you get laid off or have some other significant life change. However, if you have a lot of debt, start with one month in savings, and focus on paying off the debt because high interest rates significantly decrease your ability to save and invest. Finally, calculate your net worth, and use that number to determine the amount of cash you should keep. Start with 10% of your net worth in cash, then consider if there are any factors that would make you increase this percentage.