How much money should you be holding in your bank accounts? For most, a checking or savings account is the safe haven of their personal finances. It's where you can comfortably and confidently hold your money with safety and security. You even get FDIC insurance coverage on up to $250,000 per depositor, per FDIC-insured bank, per ownership category. It also remains liquid, which means you can access it at anytime via many different forms (cash withdrawals, debit cards, checks, ACHs, bill pay, etc.). So does this mean you should keep more of your money in your bank account? The answer to that question depends on a number of different variables. Your age, income consistency, debt load, and investment alternatives are just a few factors to consider. In this blog we are going to break down a few of the different considerations you should be using when determining how much money you should hold in your bank accounts.
- Why the consistency and stability of your income is a primary factor in determining how much you should keep in your bank accounts
- How your debt to income ratio can help you determine what amount of cash should be saved in your checking and savings
- How alternative investment options can impact your decision
- When your financial positioning will dictate your bank account balances
Hold up! Before you continue on, take a moment and download our complementary PDF; What-Accounts-Should-I-Consider-If-I-Want-To-Save-More-2021.pdf
Is a blog post not your style? That's ok, we've got you covered. Enjoy this PharmD FP Video instead! "5 Steps To Create Your Own Financial Plan"
Income Consistency and Stability
The biggest reason people save in their bank accounts is to build up a reserve of cash to use in case of emergency. This is commonly known as their emergency reserve. The instant liquidity, access, and safety are paramount. But these three factors become less of a concern when you have consistent income streams coming in. If find yourself with a good paying job that you feel is stable, then building up excess cash reserves in a bank account becomes less valuable. Some of the more common "emergencies" people save for in their bank accounts are healthcare issues, home maintenance problems, or car issues. Proper insurances should help limit the big financial risks with these three. And if you have a consistent stream of income that you can count on to meet deductibles and premiums, the value of building up a larger reserve becomes less beneficial.
The opposite holds true as well. Lets say you are in the early stages of trying to get a business off the ground. Everyone knows most businesses don't start day one as profitable. And an unprofitable, young business makes it hard pay a consistent salary for oneself. A situation like this could make it much more beneficial to hold a larger than usual amount of cash in your bank accounts. The value of the safety and liquidity of your money goes way up when you don't have a consistent backstop in place in the form of a a stable paycheck.
Or, if you don't feel you are on stable footing in your current position, saving your money in a bank account could help ease the pain of an eventual job displacement. Which I think is the primary reason people save money. If the income they are counting on to pay their bills disappears, having money available and ready to use becomes a big priority. This brings us full circle in that if you feel confident in the stability and consistency of your current income, saving excess amounts in a bank account creates a diminishing return in the form of opportunity cost missed by not having your money allocated elsewhere.
Debt to Income Ratio
A common ratio that is used to help measure the financial viability of any given person or household is their debt to income ratio. Financial institutions use this frequently to measure the risk of someone not being able to repay their debts. A larger debt to income ratio percentage would show that the individual has a higher percentage of their monthly income consumed by debt obligations.
Ex: Robert earns $135,000/year. He has a mortgage payment, car payment, student loan payment, and some credit card debt. The total monthly payment he makes toward those four debt obligations is $6,500/month. His debt to income ratio is about 58%.
It's most commonly agreed upon that any DTI (Debt to Income) ratio below 28% is considered good. Anything above 40% would show that your debt obligations may start to be putting a strain on your ability to meet other expenses. So how does this impact how much you should be holding in cash in your bank account? Well the higher your debt to income ratio is, the better off you would be to keep a higher dollar amount in your bank accounts.
This is because you are more susceptible to a sudden or unexpected cash flow issue. Those debt payments don't stop if your income drops dramatically or if you find yourself needing to replace a furnace and air conditioning unit. Disruption in income or unexpected expenses will put a greater strain on your finances when you have a greater amount of your income already being allocated to other debt obligations. So if you find yourself with a higher DTI ratio, especially if it's over 40%, you should consider saving more than just 2 months of expenses in your bank accounts.
Alternative Investment Options
This is where the conversation about how much you should keep in your bank accounts get interesting. The biggest reason people don't want to keep more money in their bank accounts than they already do is because those dollars are not earning very much. Over a long period of time, there is a high probability that your money could earn substantially more in other places compared to a traditional checking or savings account. So why doesn't everyone keep all of their money outside of traditional bank accounts if this is the case? It all has to do with risk and liquidity.
You can allocate most of your money elsewhere, but there are very few places that you will retrain the same type of security and liquidity that a bank account provides. For example, lets say that you take the majority of your emergency reserve funds and invest them into the stock market. We will also assume that a month later a big emergency happens that would require you to have to use 75% of that money. Well, you could just go into that investment account, sell your investments, and ACH your money back into your bank account. But the value of those investments may not be as high as they were when you first invested. Which means that if you were to find yourself needing that money for an emergency at the same time the investment markets were performing poorly, you could find yourself having to sell those investments at a loss and getting back less money than you initially started with. And that is the risk that comes along with it. You can't expect to get a better return on your money without taking on more risk. And sometimes that additional risk comes back to bite you.
But sometimes that enhanced risk becomes more tolerable when you know you'll be getting back a favorable tax benefit. A perfect example of this is a Roth IRA. A Roth IRA will allow you to make a contribution into the account and any growth you experience while your money is inside of a Roth IRA will be tax free (if certain requirements are met). Another unique feature of a Roth IRA is that this type of account allows you to pull your original contributions out of the account whenever you want, both tax and penalty free. Which means, the long-term tax benefits of a Roth IRA and the growth opportunity of the underlying investments you own inside the account may out-way the additional risks of needing that money at an inopportune time. So you could invest a portion of your emergency reserve in a safe and secure investment, inside of a Roth IRA, and any interest or dividends you experience will not be taxed like it would be in a bank account. All the while knowing that if you needed the original contributions for an emergency, they can be accessed without restriction.
If you find that your current financial position is really risky, increasing the amount of cash you have in your bank accounts could be a smart move. If you own a bunch of volatile assets that make up a large portion of your net worth, then a great way to start reducing that risk is to grow the more conservative areas of your financial picture. And like we mentioned before, there is no more of a conservative place to hold your cash than inside a bank account. So increasing the amount of cash you hold in your bank accounts could help you hold on to and maximize the value of your more volatile assets.
You may also find that you are in a position to take advantage of substantial tax planning opportunities. A large cash reserve can help with this. If we go back 24 months, I can point to a number of different ways a households adjusted gross income has allowed them to take part in stimulus checks, child tax credit payments, dependent care tax credits, etc. if it was small enough. Having a bigger cash reserve could help you manage the amount of income you incur within a year. You become less reliant on having to earn that money in a year because you have the financial resource of that cash in the bank to use. So in some cases, instead of earning that money in a given year to spend on your expenses, you could spend some of your cash instead. The lower income could allow you to qualify for all sorts of other benefits, like tax credits, that you otherwise wouldn't be able to qualify for. But without a larger cash reserve to rely on, this usually isn't possible for most families who count on their reoccurring income to live off of.
The "Sleep Well At Night" Factor
In some cases, it doesn't matter what the most beneficial outcome is. Some people don't care about maximizing their opportunities and instead just want to know that their money is safe and secure at the end of the day. Having an oversized amount of cash in a bank account is the perfect way to accomplish this. Over the long-term you may miss out on opportunities of growth and tax effectiveness but it doesn't matter because the sleep well at night factor trumps everything.
This usually becomes more important to people as they age. You worked hard to accumulate your money and don't want to put it at risk anymore. There will always be an argument made that you would be better off doing something else and that may be true. But if your main goal is the safety of your money, regardless of economic circumstance, letting it sit in bank accounts is the way to go.
Over a long period of time you shouldn't be relying on the "2 months of expenses" rule of thumb to determine how much cash you should keep in your bank accounts. It's a good initial starting point, but if you want to really take your financial situation more seriously, you need to dive in deeper. Your specific financial situation, both the good and the bad, should be taken into consideration together. And when you start examining it, there are many different variables available for you to consider. Figure out which of these variables will impact you the most and then start to plan your bank account balances accordingly.