How Big Should Your Cash Reserve Be?

It's a key to sound household budgeting: have a cash reserve. The rule of thumb says a cash reserve should be large enough to cover six months of expenses. Or 12 months. Or maybe just three.

With the number so flexible, how do you know how big your reserve should be?

The answer, as with so many financial matters, is that it depends.

The goal, of course, is to weather the unexpected -- anything from cost of a new water heater or roof to putting food on the table during a stretch of unemployment. You want to get through a rough patch without a dramatic change in your standard of living, and without undermining the future by raiding college savings and retirement accounts.

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How much cash will it take to do that? Well, that's why the guidelines wander over the lot. What's enough for you might be too much, or too little, for a co-worker with the same income.

Examine the numbers. "To decide on how many months worth of expenses one should have saved, I consider the general economic climate, their household structure -- are they the sole provider -- the industry the client works in, their job security and other potential liabilities that may arise, such as home repairs or dependents," says Matt Hylland, a financial planner with Hylland Capital Management in Virginia.

"According to the most recent release from the Bureau of Labor Statistics, about half of those currently unemployed have been without a job for 15 weeks or more," he says. "This highlights the need for an emergency fund able to cover at least three months worth of expenses at a minimum."

To zero in on a number, Hylland says, write down your expenses. Note how much you actually spend every month, starting with big-ticket items like the mortgage and car payments, utilities and groceries. Then list the little items like meals out and movies that can add up to hundreds a month.

Next, subtract from the grand total the expenses that could be cut without serious damage to your way of life. You wouldn't cut your kids' college tuition, but could easily do with cheaper cable or phone service, eating at home and sticking with the same wardrobe for a while. The result is your essential cost of living.

After that, figure how dependable are your sources of income. A civil service or union worker with lots of seniority will have better job security than an hourly fast food worker, or someone who depends on commissions.

"If you're self-employed, work on commission, or work in an unstable industry or position, you should double or even triple that [six-month] baseline," says Joseph C. Newtz, an independent financial advisor in Beaver, Pennsylvania.

Separate your reserves. The emergency fund is for unexpected expenses. "This money should only be used for true emergencies such as an exorbitant medical cost or job loss," Newtz says.

Cash for planned expenses, like a home improvement, new car or a down payment on a new home, should be saved separately, he says.

Though most people have a sense of the health of their company and industry, it's worth looking a little deeper from time to time to figure how you would fare if worse comes to worst. Check out the job listings on Craigslist, Monster and similar sites to see if your talents are in demand, and whether finding a new job might require moving.

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Also figure what benefits you might receive if you lost your job. Would there be severance pay, continued health care benefits or help in finding a new job? To find out what you might receive in unemployment benefits, there are online options to research jobless benefits in your state.

For most people, it's not possible to have a fund large enough for every possibility, such as permanent unemployment. The goal is to save enough to cover costs until you get back to the life you had before. If, after going through these steps, you're fairly confident you could do that in six months, then a six-month fund will do.

Set money aside automatically. Once you've set a target, open a checking, savings or money market account dedicated to the emergency fund. Shomari Hearn, vice president of Palisades Hudson Financial Group in Fort Lauderdale, cautions against mingling the emergency funds with cash used for routine expenses. "You want to have access on short notice, while avoiding the temptation to use these savings for non-emergencies," Hearn says.

"Put your emergency fund contributions on auto-pilot by setting up recurring monthly transfers from your checking account to your (emergency) savings account," Hearn says. "If the transfers occur automatically, you are more likely to reach your savings account faster than if you leave it to yourself to fund the account without wavering."

Layton Cox, co-founder of My Pathway, an online investing service based in Tucson, Arizona, recommends two accounts. The first is a short-term cash reserve to cover expenses for a month or two, or to pay for a car repair or other unexpected expense of less than $3,000.

Invest to cover crisis. The second is a long-term emergency fund to cover a major crisis, like a job loss, that may occur only once or twice in a lifetime, or perhaps never. Because this money may not be used for many years, it should be invested to keep up with inflation, which an ordinary bank account will not do, he says.

"The way to fix this is by investing it into a diversified conservative portfolio with a target rate of return of around 4 percent for the long term," he says, suggesting the fund be large enough to cover six months' expenses. "This isn't your day-trading account, this is an account you almost forget you have until you have a huge problem."

A short- or intermediate-term bond fund might fit the bill. It will earn more than bank savings, will adjust automatically as market conditions change, and could be tapped quickly if the bank savings run short. The key is to not rely on volatile investments like stocks, because selling in a down market can do long-term damage to investment returns.

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Hylland says Series I and Series EE U.S. Savings bonds also offer a good fallback holding, since they pay more than bank savings or money market funds. Keep in mind they must be held for a year before they can be sold.

"These securities make it a little easier for someone who may be struggling to save enough for their emergency fund but also wants to save for their college expenses," he says.

Homeowners also can set up a home equity line of credit, says Chris Cortese, a financial advisor with Wescott Financial Advisory Group in Pennsylvania. There will be no interest charge until you start drawing on the account, which may never happen.

But don't wait until an emergency to set up your credit line, since the lender will require proof of enough income to make payments.

Jeff Brown spent nearly 40 years as a newspaper reporter, columnist and editor, including 20 years writing about investing, personal finance, the economy and financial markets. He spent 20 years at The Philadelphia Inquirer and has been freelancing since 2007.