Saturday, February 17, 2007

How much cash reserve should you keep in your bank account?

 Liz Pulliam Weston over on MSN Money has an article entitled "Why you need $500 in the bank - Having a few hundred bucks at the right times in your life can make all the difference. Here's how to tuck away money for emergencies, even if you don't have much" which recommends that we all try to maintain a $500 "cushion" in our bank accounts.

Nobody is immune from occasionally forgetting about a recent check or charge or an upcoming expense (particularly those that are not recurring monthly expenses) and either being lucky enough to find themselves short or being unlucky and being hit with an overdraft.

Sure, some of us have the credit history to merit overdraft protection (a credit line) on our checking accounts, but even then the purpose of the credit line (a convenience for the bank) is that you will use it and start paying interest on the balance. Keep the so-called "cushion" and you won't have to worry about the potential interest or pain of coming up with the extra cash to avoid the interest when an unexpected expense does hit.

Even with a balanced monthly budget, there tend to be one or two times during the month when a rush of expenses hit a week or even days before you have income that will easily cover those expenses in the overall monthly budget. The cushion eliminates the need to worry about such times.

The only downside to a "cushion" is the interest income you lose in a bank account compared to a higher-yield money market mutual fund or even a bank CD. That was a primary motivator for me moving most of my banking away from traditional banks and into a brokerage account. Not that the monthly interest on $500 is that much ($1.85 at Fidelity or $3.69 for a $1,000 cushion), but the thought that the bank is effectively charging me an extra service fee when they are not offering an additional service is rather annoying.

My intention had been to keep a $1,000 cushion in my main Fidelity brokerage account which I use as a combination checking and savings bank account as well as the destination for my employee stock purchase plan. I have a lot more than $1,000 in the savings portion of the account as my rainy day contingency fund (a year of expenses), but I mentally do not count that as part of my "cushion."

Fidelity has this concept of "core cash" which is the default money market mutual fund that incoming cash goes into and expenses (checks, debit card expenses, stock or mutual fund transactions, and electronic money transfers) come out of. Unfortunately, the fund choices for core cash are very limited and yield a lot less than the full offerings in the "savings" side of the account. So, I ended up putting $500 of that $1,000 in my PayPal account which yields more than any money market mutual fund Fidelity offers me (5.02% vs. 4.93% on FDRXX or the taxable equivalent yield of 4.43% for the tax-free FTEXX fund that is the best I can do with core cash).

Incidentally, I derived the $1,000 number from the fact that my second paycheck of every months comes on the last business day of the month and if there was any reason why it wasn't credited promptly (yeah, I don't trust computers to always "do the right thing"), I would be almost $1,000 short on the 1st of the month for my rent and utilities. I may never hit such a problem, but having a $1,000 "cushion" would guarantee it and give me rock-solid piece of mind.

Since I can quickly "sell" $500 from my rainy day fund on the savings side of the account, I'm not totally exposed. I may yet go to maintaining the full $1,000 cushion, but having that extra $500 earning less interest annoys me a little. The financial "loss" is minimal, a whole 30 cents in lost interest compared to PayPal, but its the principle of the thing and the fact that Fidelity has me over a barrel and is using my money at a discount.

I still have an old-fashioned, traditional bank account with Wells Fargo (their stage coach is a great symbol for my attitude towards traditional banks) and actually direct deposit a small portion of my paycheck there simply for the convenience and lack of fees of the ATM machines. I still use that bank account for my TreasuryDirect T-bill transactions as well, so it gets a small amount of additional monthly deposit from that source as well. I don't want to accumulate too much cash in an account that pays less than peanuts in interest, but the piece of mind of being able to get a few bucks no matter what is going on in my Fidelity account is worth the 36 cents of interest that I am foregoing. Every other month I transfer the "excess" cash from the bank account to Fidelity.

I try to be strict with my budget and have enough slack built into my budget that I frequently accumulate a modest excess "cushion" in my Fidelity core cash, which I then transfer either to PayPal or the higher-yielding "savings" side of my account. The key advantage of the PayPal account besides its higher yield is the simple principle of "out of sight, out of mind." After all, with financial matters, comfort and complacency are the roots of all evil. We all need tools and tricks to extend our skills beyond our limited raw abilities.

-- Jack Krupansky

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