After paying down debt, getting an emergency cash reserve is the next thing to do when building a solid financial base. The only exception to this is maxing out your 401(k). Always take advantage of your 401(k) match regardless of your debt or emergency fund situation.

What is the ideal amount for a cash reserve?
Everyone has a different standard of living, career, and tolerance to risk. With that said, the primary reasons for having an emergency reserve are the same. Firstly, we don’t want to damage our credit when tragedy strikes. Next, we don’t want to be evicted from our homes. Lastly, the added stress of financial problems isn’t worth it. Extra cash adds a ‘buffer’ that protects us from life’s unexpected ups and downs.

An emergency cash fund should cover:

  • Mortgage or Rent payments
  • Insurance costs
  • Utility bills
  • Groceries
  • Car payments
  • Student Loans
  • Minimum payment on credit cards

A standard cash reserve goal should cover six months of expenses. If your monthly expenses total $2000 you should plan on a cash reserve of $12,000. Six months is a starting point but there are other factors that you might consider. If your job is in high demand you might be able to lower your time from six months to three. The economy’s strength is a factor as well. In times of recession (or suspected recession) it might be wise to pull some money out of high risk investments and build your cash reserve.

Word of warning

While having cash handy for emergencies is a wise decision, too much cash can actually hurt you in the long run. There is a balance between cash and investments. Saving too much cash can undermine your investment and retirement goals. Excessive cash holding is risky in terms of opportunity cost. Opportunity cost is the difference between what you could have made VS. what you actually made. For example, an NBA basketball star could take over his families furniture store and make $100,000/year after graduation. On the other hand he could play for the NBA and make $10,000,000/year. The opportunity cost of taking over the family business is $9,900,000. That same idea of opportunity cost plays a big role in determining the ideal balance between cash and investment. A few percentage points makes a world of difference in terms of compound interest.

Where to keep your cash

Where should you keep your cash? Keeping your cash in an account that will keep up with interest is important. Stuffing money into your mattress isn’t going to keep up with inflation. With the Fed cutting interest rates the return on FDIC insured savings accounts have decreased from over 5% to 3.75%. While the decrease is unfortunate one fact remains; online savings accounts are still the safest (and most profitable) when compare to other alternitives — which aren’t FDIC insured. Read more about online savings accounts with high interest.

The CD Shuffle
If Certified Deposits (CDs) were more attractive right now this strategy would optimize the return on your cash reserve. Unfortunately CDs, according to BankRate, were all under what you could receive with an online savings account.

If the interest rates on CDs ever improve beyond online savings accounts you could use this strategy. The concept requires multiple CDs being opened with different expiration dates.

Your first purchase would include the following:

1 month CD (expires in 1 month)
2 month CD (expires in 2 months)
3 month CD (expires in 3 months)
4 month CD (expires in 4 months)
5 month CD (expires in 5 months)
6 month CD (expires in 6 months)

As a month passes your 1 month CD will expire. Take the money from that CD and buy another 6 month CD

2 month CD (expires in 1 month)
3 month CD (expires in 2 months)
4 month CD (expires in 3 months)
5 month CD (expires in 4 months)
6 month CD (expires in 5 months)
6 month CD (expires in 6 months)

As the second month expires take that money and buy another 6 month CD

3 month CD (expires in 1 month)
4 month CD (expires in 2 months)
5 month CD (expires in 3 months)
6 month CD (expires in 4 months)
6 month CD (expires in 5 months)
6 month CD (expires in 6 months)

After 6 months every one of the CDs will be 6 month CDs. As the CDs expire continue to buy new 6 month CDs.

6 month CD (expires in 1 month)
6 month CD (expires in 2 months)
6 month CD (expires in 3 months)
6 month CD (expires in 4 months)
6 month CD (expires in 5 months)
6 month CD (expires in 6 months)