Is a cash reserve necessary?

February 15, 2013

I met with a couple recently to deliver their financial plan, and throughout the first half of the meeting we laughed repeatedly as they seemed to have guessed my recommendations and either did or planned on doing exactly what I had written down.

 

They’ve been contributing 15% of their wages to their long-term retirement plan, have no debt other than a mortgage that will be paid off well before retirement, are able to pay a college tuition bill within their cash flow, and up until recently have been making it a point to contribute to Roth IRAs.

Aside from the validation from a professional, what possibly could this couple have needed with a financial advisor?

 

Admittedly, not as much as many clients I see, but one of the major observations was the excessive amount of importance on trying to be as efficient as possible. They put every available dollar towards the long-term retirement plan or into paying down their long-term mortgage debt, and in doing so they blew past step one in creating a solid financial foundation – having an adequate amount on hand for short-term emergencies and cash needs.

 

Our sample couple here came to me wondering how in the world they will be able to pay for a second tuition bill, or purchase new cars. They recently stretched their budget even further by refinancing their 30 year mortgage to a 15 year, and increased their monthly minimum payment. I also pointed out that they had no options to cover any other short-term emergencies that life may send their way other than to go into debt, or raiding a retirement fund.

In preparing their recommendations, I gave them a financial scorecard they would receive the following grades:

 

Long-term savings – A+

Credit and consumer debt – A+

Living within their means – A+

Having adequate liquidity – D

Overall financial health – B-

 

What this couple was lacking is cash on hand. Unlike most of your other financial priorities, holding cash is never the most efficient thing to do and so its importance is often overlooked. Compared with paying down a mortgage at 4%, or earning 5-10% in a long-term investment, cash earning next to nothing just isn’t an attractive idea!

 

But, having an emergency cash reserve is a critical piece of a financial plan. It acts like a moat around your financial castle. It protects you from the need to sabotage your long-term investment plan, or take on high interest debt in order to cover cash needs.

 

Having a minimum of three months of your net income in an emergency cash account is a requirement of any complete financial plan (Note: three months is a minimum. If you are self-employed, have rental properties, or other concerns about income remaining stable you may need to be at six or more). Even at the expense of not fully funding a retirement account or not paying extra on that student loan for some time. Make having emergency cash in a savings account or money market a priority now, and when the time comes to need it you won’t have to worry.

 

The preceding blog was originally published by the Financial Planning Association®(FPA®). To view the original blog please visit the FPA Web site

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