Question from our GenYmoney Facebook group: I would love to learn the right amount of cash sitting in one’s bank account for daily living, so if you are holding too much cash or too little (assuming all debts and loans are paid off).
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Ben Felix provides one-on-one financial advice sessions about investing, insurance, financial planning, and anything else personal finance related.
Benjamin Felix is an investment adviser with PWL Capital in Ottawa.
Answer: There is an opportunity cost to keeping cash: it will always have a lower expected return than riskier investments such as stocks and bonds. Why hold any at all? You may occasionally need cash in excess of your income, and it has to come from somewhere. If you don’t have it in your bank account, you will be forced to go into debt or sell some investments to cover your cash needs. Avoiding debt is obviously a good thing. Selling your investments could result in a loss, if their value is down when you need the cash.
Getting a handle on expenses
The right amount of cash to hold starts with defining your budget. A good budgeting tool that I use is YNAB, but an Excel spreadsheet can be just as effective. Once you have a budget, you will know what your monthly expenses are. Now you can start planning your cash needs.
Living expenses
For day-to-day use, it makes sense to keep one month of living expenses in cash as a spending buffer. This avoids living paycheque to paycheque – you are always spending money that you actually have.
Emergency fund
Most people should keep three to six months of living expenses in cash for emergencies. A homeowner should lean more toward six months. The six months of expenses number is not extremely scientific, but it doesn’t come out of thin air. Based on 2013 data, a 2013 Toyota Camry had an average annual maintenance cost of $1,020; it’s reasonable to budget about 1 per cent of a home’s value per year for maintenance costs ($548,517 is the national average home price as of March); the average duration of unemployment in Canada is about five months. Keeping three to six months of living expenses in cash should cover most emergencies.
Planned expenses
Not everything is an emergency – some large expenses are planned. If you have a big expense coming up, you might be (and should be) saving a monthly amount to pay for it. If the expense is expected within the next year or two, this cash should not be invested in stocks or bonds. Cash for planned expenses should be kept in excess of your emergency fund.
Lines of credit
Right now, money is cheap to borrow. With interest rates as low as they are, you could opt to not keep any cash on hand and instead apply for a line of credit. The interest rate that the bank attaches to your line of credit will depend on your credit score. If you have a great credit score, or a home to secure against, this may be a more viable option. The risk with a line of credit is that they tend to have variable interest rates. If you are carrying debt and interest rates spike, you might find yourself in an undesirable situation.
The right amount of cash
You should keep a float in your chequing account of one month of living expenses. This way you will always have cash available for your regular living expenses, and should have no reason to dip into savings under normal circumstances. Your savings account should have enough cash to cover between three and six months of living expenses to be drawn on in the event of an unexpected expense or loss of income. If you have known large expenses coming up, you should keep enough cash on hand to cover them. Holding onto any cash above these amounts is probably an inefficient use of those dollars, which could be invested in riskier investments with higher expected returns, like index funds.
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