How Much Money Do You Need in Savings?

by AJ Pettersen · 13 comments

Coins falling into a piggy bankThe bank is a great place to keep money safe and readily available, but how much money do you really need to keep in your savings account?

My wife and I are facing this exact question. With a transient lifestyle and a plan to head south in January, we need to have a buffer in our account, but are unsure how to determine the appropriate amount.

There are a number of things to keep in mind when deciding how much liquid cash you should keep in the bank.

Emergency Fund

My wife and I want to keep enough money in our account so that, if necessary, we can live without much income for a few months. She’s trying to get a job in the south, but it may end up being temporary. Having enough in our account to ensure that we can afford rent, gas, and other necessities is vital.

The amount of money in an emergency fund will vary for everyone. If your family has two stable jobs, then the fund can obviously be smaller, as long as you account for your mortgage or other high fixed monthly payments.

Debts

Do you have debts? This would include mortgages, car payments, student loans, and credit card balances. Debts accumulate interest at a rate far higher than your bank can offer in return. It’s quite difficult to find a bank that will offer more than 1% in a money market account, while loans have interest rates that are much higher.

My wife and I are still paying off student loans that have variable interest rates. At the moment, these are 3-4%, but they could increase in the future. Paying these loans down, rather than letting funds sit in the bank at less than 1%, could be a good option for us.

Finding the right balance between paying down debts and keeping enough liquid funds in the bank is key, as overpaying on debt can take years off of the total payment time.

Investing

And then there’s investing. Could this be a good option for you? Placing some of your funds into a retirement fund or mutual account can be a great way to get a return on your investment. Though investments average a much higher return than the bank, they are far more volatile; they can lose money some years and pay huge returns other years. Letting things play out over time is best because it will allow you to achieve the average return.

My wife and I are considering investing to increase our retirement funds and also to save for a down payment on a house. One thing to consider is that the risks involved should directly coincide with the amount of time you want to keep the money in a certain investment. While shorter investments should have less risk, you can afford more risk with longer investments, as you’ll recoup losses over time.

What’s the best solution for you?

The best solution will be different for everyone. It’s important to know your financial situation and be aware that things can (and will) change in the future. You also need to account for big life decisions, and budget around these. Factoring in all of these elements will help you determine how much liquid cash you need in your savings account vs. how much money you should use to pay down debts and invest.

How do you decide how much money to keep in your savings account?

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{ 13 comments… read them below or add one }

Chucks December 5, 2012 at 4:39 pm

Uhm, absolutely nothing. A savings account is absolutely silly and outdated concept. No savings account today is delivering returns above inflation, so you’re actually getting poorer keeping money there.

That’s not to say I don’t save money, actually most of my income. But it goes into investments that actually grow. Since I live well below my means, fluctuations in the stock market aren’t going to affect whether or not I can pay out for an “emergency”

And really, how many emergencies are going to require immediate action and can’t be handled with a credit card and paid off in 30 days, interest free?

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Perth Book Keepers December 5, 2012 at 7:51 pm

Its good to have something extra in hand because we’ll never know when certain financial difficulties might occur or happen. Better be prepared than sorry.

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AJ December 6, 2012 at 10:04 am

The amt depends on your situation. Three-six months of expenses is the standard emergency fund. I would stop all investments during a true emergency such as job loss. You’d need a bit more if planning on moving. You need transporatation, temp lodging and deposits for renting, at the very least.

I do not recommend using the credit card. The possibility of having the money to pay it off in 30 days is just too big a risk in a true emergency. However I do agree with making your money work for you. After you have some money set aside, you can start a Roth IRA. If I recall the rules correctly, you withdraw any of the principle after five years without and penalities. Thats why you should have cash onhand till at least the five years has past.

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Chucks December 6, 2012 at 1:01 pm

I recommend the credit card just to show that there’s no need to have cash in a savings account- that cash can be invested in the stock market instead. No emergency requires cash instantly, short of I don’t know, a kidnapping or something. It might take an extra 3 or 4 days to get money out of a stock market account, but whatever. You’ve got a 30 day interest-free loan which you should be able to pay off instantly. And if you can’t pay it off in full (which would require extraordinary circumstances, since you have invested all that money in an index fund) you’ll have to pay interest- but that’s going to cost far less than the amount you’re losing in a savings account.

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AJ December 6, 2012 at 4:28 pm

I hear you, Chuck. It works for you. That may not work for those without significant investments already available.

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CReitsma December 8, 2012 at 8:28 am

I prefer to keep a “Cash Flow Schedule” where I map out my expenses by month. I then use three indicators to evaluate my emergency fund’s financial standings: My Cash Buffer – how much extra cold hard cash I have left over after I pay my expenses, my quick ratio – which is a ratio of my cash buffer (cold hard cash) to my current liabilities (monthly expenses) so I can see how sensitive my cash buffer is to my expenses (how good must I be to maintain my budget), and my current ratio, which is my “current assets” or those I have money in (checking, savings) or those I could pull money out of with ease (stocks, bonds, and money market accounts), which measures my ability to pay if I’m in a pinch.

What you are looking at for an emergency fund is having cash if needed in an emergency, which means there’s reduced or no income available. Assuming you aim for financial independence, this means quick access to cash. A current ratio will give you an estimate of how many months of your current monthly expenses you could pay with the access to cash you have available.

Current Assets = Cash (Savings, Checking) + CDs + Stocks + Bonds + Money Market + Monthly Income
Current Liabilities = Monthly Expenses (use those from your budget)

Current Ratio = Current Assets / Current Liabilities

A current ratio of 300% would mean that with your current assets (those you could get to with ease), you could pay 3 months of expenses (assuming your expenses don’t go up or down). Using the current ratio, you can easily get insight into your access to cash, and budget appropriately.

Notes:
1) If you have payments that occur sporadically throughout the year, such as a once a year or every 6 months (like insurance), you should not include money set aside for those payments in your current assets.
2) Some accounts, such as stocks will have a trade fee, so the numbers will be off by a few dollars per stock in a company. If you have a lot of stocks in different companies, it may be a substantial amount to trade those in if need be.
3) Also, stocks do have variability, and in the event the market were to crash at the same time as you needed your emergency funds, you would not have as much cash available as you expected if a majority were in stocks. If you do not want to expose your emergency fund to risk, only use your current ratio to reflect money markets, bonds, CDs, checking and savings accounts.

Roth IRAs are a bad place for an emergency fund because they will charge a 10% withdrawal fee.

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Sarah December 13, 2012 at 12:02 am

A cash flow schedule is very helpful in monitoring my income and expenses. In this system, I can clearly see if I already spent much more than the income I have in my hand. I see to it that in preparing the cash flow schedule I will never neglect all the approximate expenses and other responsibility I have in order to have a good standing of financial stability. I see to it also to maintain a good standing on my credit, not delaying or neglecting to pay any debt I have scheduled monthly.

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AJ December 8, 2012 at 1:00 pm

CR,

Interesting computations on how much cash to have onhand. I use a similar system just much simplier.

There is no tax penalty on a Roth IRA of principal. That does mean there are no fees with the institution holding the account. People will have to research the institutions.

http://money.cnn.com/retirement/guide/IRA_Roth.moneymag/index5.htm

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CReitsma December 8, 2012 at 2:24 pm

AJ,

There’s beauty in simplicity. If you don’t mind sharing, I’m sure a lot of folks would like to see your system.

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AJ December 8, 2012 at 2:37 pm

Thanks for asking. I take all expenses other than mortgage and divide by the number of paychecks in year, i.e., 12 if paid once a month, 52 if paid weekly. Make a spreadsheet with pay dates in the first column (A). Next column (B) has the base paycheck; no OT or bonuses. The next col (C) the averaged expense amt. Col D with monthly mortgage only on the last paydate of each month. Col E with current bank balance. Col F estimated overage after additions and subtractions. Anything over the cold hard cash on hand amt goes to paying extra principal on the mortgage or a temp savings for a special project.

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CReitsma December 8, 2012 at 5:34 pm

Your approach also makes sense. The main difference between our methods is that you prefer to work with your emergency fund in cold hard cash or pay down your mortgage to reduce interest charges, and I prefer to put my money into easily accessible investment accounts to earn interest. Likely the differences depend a bit on personal preferences (cash versus current assets), and a bit on the interest rates we each are earning for loans versus investments. If you earn higher interest on your investments than you pay on your loans, it’s better to increase money in investments, if you pay more interest on your loans than you would get back from your investments, it’s better to put your money towards paying off your loans. Thanks for sharing AJ.

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AJ December 8, 2012 at 6:47 pm

Thank you, CR. yes, everyone has their own approach. A lot depends on where one is in life. My paycheck already removes the max for a 401k and a Roth, so the rest is what was calculated. Since most of the principal in the Roth is over 5 yrs old, the cold hard cash is only a few months of expenses. Since the only interest pd is on the house, thats what I concentrate on paying off. If I had student loans, credit card bills, the focus would totally different.

The author spoke about moving. I’m leaving here in a pine box so I don’t need to save up for additional expenses to find a new home. I had saved up for large purchases when I decide there’s something I really want. Instead gradification isn’t in my vocabulary. ;-)

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Mike Della August 5, 2013 at 11:51 am

This is such a great topic. People do not always realize how much money they need in their savings account. It is important to save for a rainy day. The best way to prevent debt is to always be ahead of the game and savings allows you to do this. Debt consolidation can help you plan your finances so you aren’t in this situation again.

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