Financial Planning 101 – Excess Cash and Emergency Funds

Boy with coin. West Financial Services.

We continue our Financial Planning 101 series with the balance sheet, by addressing what to do with any excess cash. If you don't have excess cash, then we will go over the importance of building up an emergency fund.

Let's start with that last one, as it is possibly the one thing that everyone should target as a goal. In financial planning, the emergency fund is just an account in which you accumulate enough cash to meet a certain level of living expenses. True to its name, it is meant to only be accessed should there be an emergency.

How much of an emergency fund you need is dependent on a few factors, including the stability of your income and your comfort level. For most people with a consistent income, we recommend having three months' living expenses set aside for emergencies. But if your income is not as consistent, or you are more risk averse, you can save as much as six months' expenses. Anything more than that and you may be missing an opportunity to invest for growth.

If you don't currently have any emergency savings, prioritize a plan to build it up by making automatic payroll contributions to a dedicated bank account. We recommend that clients keep their emergency fund in the highest yielding savings vehicle that they currently have access to. Sometimes that means opening a separate money market account within an existing banking relationship. You could just as easily keep your emergency fund cash as part of a money market balance in a taxable brokerage account.

Another way of establishing a source of emergency cash if you own real estate, is to get a home equity line of credit (HELOC). A HELOC is a loan based on the equity you have in your home, or another piece of real estate. Interest rates for HELOCs are typically variable and will change along with the market. The good news is that you don't have to pay any interest for having a HELOC, unless you take money from the loan balance. We like to recommend having the loan available, but not using it unless absolutely necessary.

Once you have established emergency savings, you might find excess cash accumulating in your bank accounts. Given that checking and savings accounts have had very low yields in recent history, this is not where you want to leave money that you don't immediately need. Once you have excess cash accumulation, it is time to establish a longer term investment strategy that targets more growth. This means setting up an investment program, either through payroll deduction or bank transfer, which keeps your longer term savings consistent and growing.

What we tend to see in financial planning is that people who are able to maintain a pattern of saving outside of retirement plans have more positive outcomes in retirement. There's a reason why your parents always stressed living within your means. It is a good strategy, allowing you to have a comfortable lifestyle, regardless of your income level.

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