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What Are Cash Reserves and Why You Need One

What Are Cash Reserves and Why You Need One

Always plan for the future and be prepared for the unexpected. One approach to be prepared for anything is to build up a little financial reserve that can be utilized in an emergency or unexpected opportunity. If you are looking into creating a cash reserve to feel more prepared for any unexpected events, this article might be helpful. You will learn what cash reserves are, how they work, and how to create one. So here we go.

What Are Cash Reserves?

The money a business or individual keeps in hand to cover emergency financial requirements is referred to as cash reserves. Cash reserves are short-term investments that provide clients with immediate access to their funds in exchange for a lower rate of return. However, nowadays not every option of cash reserve offers low-interest rates to its clients. Online savings accounts from banks like Ally and crypto-based savings accounts, such as Outlet Finance, are cash reserve options with very good return rates. More traditional examples of cash reserves are money market funds and Treasury Bills (T-Bills).

How Cash Reserves Work

Having a big cash reserve allows an individual to make a large purchase right away. It should also guarantee that they are able to cover themselves in the event of a financial setback or the need to make unexpected payments.

According to experts, individuals should keep enough cash on hand to last three to six months in the event of an emergency. If you are looking to build a financial reserve, you should keep it in bank accounts or in low-risk, short-term investments that are unlikely to lose value. That manner, regardless of how well the stock market performs, you will be fine. You will either be able to withdraw your emergency cash or sell these investments at any moment without losing money.

Individuals with insufficient financial reserves may be compelled to use credit. This can mess with your credit score and directly impact your financial future. In the worst-case scenario, the lack of a cash reserve can result in needing to declare bankruptcy.

The Importance of Cash Reserves

Cash reserves come with great advantages that can shield your financial health and allow you to pursue growth. These are the main reasons why cash reserves are so important:

You're more equipped to deal with unforeseen expenses.

Financial planning is essential in a reality where anything may happen at any time. When faced with an unexpected expense, having a cash reserve helps you cover these expenditures without draining your bank account.

Your current financial condition is unaffected.

When you don't have a cash reserve and an unexpected expense arises, your alternatives are restricted. To deal with the expense, you may have to interfere with other investments or savings accounts. Doing so would only slow down your progress toward your financial goals. With a cash reserve in place, your other financial accounts are shielded, and you avoid debt from taking a loan.

You can take advantage of good opportunities that surge.

New investing prospects frequently necessitate an outlay of funds. Cash Reserves allow you to take advantage of any opportunities that emerge without having to rely on consumer debt. This type of debt, such as credit cards, usually comes with high-interest rates that are difficult to pay off.

Cons of Cash Reserves

Cash reserves might seem to only bring advantages. However, depending on where you place them, the interest rate of your investment, and your financial balance, they can have some disadvantages.

When there are cash flow issues and money is needed immediately, having cash reserves can be very helpful. However, striking the correct balance is critical, since too much may be harmful.

Excess cash in the bank might lead to lost opportunities. Investing part of that excess income into a better yielding investment can result in higher gains. In principle, the amount of money generated by those assets should easily outperform the interest rates offered by a checking account or a traditional savings account.

Keeping too much money in cash reserves may be harmful to individuals. Yes, they are more secure. However, they yield far lower returns than, for example, diversified portfolios of stocks, bonds, REITs, gold, alternative assets, or any other asset class. Due to inflation and the force of time worth of money compounding, this disparity becomes quite obvious over time.

Choosing the right investment for your financial reserve is also crucial. Having money sitting in an investment with an interest rate lower than the inflation interest rate will end up with you losing money. Nowadays, there are great options of low-risk and liquid investments that offer interest rates that surpass the inflation rate. Some of these are online savings accounts such as Ally, and crypto-based savings accounts, such as Outlet Finance. The latter can offer a rate of up to 5%, making it a great place to have your cash reserve.

Ultimately, it is all about having the right amount of cash reserve at the right place. But then how much money should I have in my cash reserve and where should I place it?

How Much Should I Have in a Cash Reserve

It's debatable how much money you should put aside for a cash reserve. It should at the very least cover three months' worth of living expenditures. Six months is preferable. Then, some planners even suggest a year.

If, on the other hand, you use your credit cards in an emergency and end up paying 15% interest, you'd be better off accumulating enough money to cover your needs for at least six months. And if your income fluctuates—perhaps you're self-employed or rely on commissions—having a larger cash reserve is a good idea.

Where Should You Have Your Cash Reserve?

There are some types of investments and accounts that can serve as a place to have your cash reserve. What you should look for is a type of investment that is secure and liquid.

Secure because this is the money you will use in case everything goes wrong. Thus, you can't risk that your financial reserve is also gone in an economic setback, for example.

Liquid because this money is intended for unexpected events and the thing about those is that you are not expecting them. You can’t plan for unexpected events, which means you need to be able to access your cash reserve whenever these unplanned incidents happen. So you need your financial reserve to be placed in a liquid investment.

As explained, it is also a smart decision to pick an investment to place your cash reserve that offers interest rates higher than the inflation rate. This way, you will avoid the loss of value of your cash reserve, or even grow this money for the future.

Taking these aspects into consideration, there are some options of investments and accounts that can keep your financial reserve safe and ready to be used. The following are some of the most popular places to have your cash reserve:

  • Checking Account
  • Traditional Savings Account
  • Online Savings Accounts
  • Crypto-Based Savings Accounts
  • Money Market Fund
  • Money Market Account
  • Short-Term Treasury Bills (T-Bills)
  • Short-Term Certificates of Deposit (CDs)

How Do You Build Your Cash Reserve?

You don't have to fill your whole financial reserve in a week. Most people begin by setting away a monthly sum, such as 5% of their income or another number that allows them to accumulate one month's worth of living costs over the course of a year.

There are some tricks that make the whole process simpler for you, especially if you have a hard time following a budget. For example, set up an automated deduction program from your checking account to your savings account. This way you won’t spend the money that is supposed to go to your cash reserve.

Also, keep track of your monthly expenditures and search for places where you can save money. You might be surprised to discover places where you can save money and strategies to streamline expenses you never considered. If you earn any promotions, job bonuses, or other unexpected windfalls, consider putting it into your financial reserve rather than spending it.

The Bottom Line

Having a cash reserve can bring some security to your life. With one, you know you will be fine in case of an emergency, unexpected incident, or even an economic crisis. On top of that, you will be able to take advantage of financial opportunities that demand some initial investment. Just keep in mind that having the right amount at the right place is very important when it comes to cash reserves.

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