How much cash should you have in your rainy day fund?

Sep 27, 2023Personal Finance

Poor rates of interest and high inflation undermine the argument for a big emergency stash in an easy-access account.

It is a first principle of financial planning that everyone needs an emergency fund. The idea is that investors should always have enough money to cover three to six months of regular outgoings in an easy to access account. Just in case the car dies, or a family member loses a job or gets sick.

For the past couple of decades, investors haven’t had to think very hard about where to stash their cash. Interest rates and inflation were so low that it didn’t make much difference whether the money was in a checking account, a high-yield savings account or a non-bank money market fund. None of them paid very much and cash largely held its value over time.

That is no longer true, as I discovered to my chagrin last month. Years ago, I opened an online savings account at Capital One, a Virginia-based bank that promised better rates than the lender where I have my current account. Yet the interest rate on my savings had barely budged over the past year, staying below 1 per cent even as the US Federal Reserve hiked the policy rate past 5 per cent.

Yet Capital One paid an average of 2.54 per cent for deposits in the first quarter, more than triple year on year, and well above the 1.85 per cent average paid by its peers, according to analysis by BankRegData. And my daughter happened to mention that she was getting 3.5 per cent on a Capital One account she had just opened. So I called customer service.

You have an old product, they said. You need to open a new account to get a better rate. In other words, they have been stiffing unwary long-term customers like me while offering sweeteners to attract new ones, like my daughter. (Capital One said it is “proud to offer a range” and “encourages customers to regularly review” to be sure they are in the best ones. In other words they think it’s my problem.)

Personal finance experts say this is a common story and one investors need to be aware of on both sides of the Atlantic. UK banks routinely offer cash bonuses for opening new accounts and MPs recently castigated the high street banks for offering “measly” interest rates.

Rather than parking their entire emergency fund in a current account, investors should think about layering their cash, says Georgia Lee Hussey, a wealth manager based in Portland, Oregon.

Everyone should have “half a month or a month of extra cash in your checking account” plus another month of back-up in the savings account attached to the checking account, Hussey says. After that, the next two to four months of cash should go into a high-yielding savings account, often at another bank that offers easy online access and better interest rates.

Recent ructions over uninsured deposits after the collapse of Silicon Valley Bank serve as a reminder to keep the total amount in each institution below the cap on government protection schemes: $250,000 per account in the US, £85,000 per person in the UK.

In all cases, investors should shop around for better rates and take advantage of cash bonuses that some banks give to investors for opening a new account.

The big question now is what to do if you have more than six months of cash on hand. Large numbers of investors who saved additional money during the pandemic have been reluctant to plough it into equities and bonds after last year’s turbulent markets. And investors saving for a near-term goal — a tuition payment or down payment on a house, for example — may not want to risk losing their principal.

“The amount of money that is sitting on the sidelines is epic,” said Rick Rieder, chief investment officer for fixed income at asset manager BlackRock.

If the markets seem too scary, term deposits and money market funds are an option but each have downsides. Term deposits lock up cash for a specific period, often with a substantial penalty for early withdrawal. And money market funds, although they offer instant access, are not covered by deposit insurance because they are not banking products. Record recent inflows in the US into these funds, which invest in very short-term securities, have led US Treasury Secretary Janet Yellen to warn that they could be subject to runs at a moment of crisis.

Financial advisers warn that cash is an area where you really can have too much. It may feel comforting to have five years of income sitting in a bank account, and it is easy to be wowed by safe accounts that promise returns quadruple what was available only a year or two ago.

But the sad reality is that inflation is staying high, so the value of that nest egg is eroding every day. Long-term savings, whether for a house purchase in a decade or retirement in 20 years, do not belong in a cash account. Studies have shown that investors who try to sit out scary periods in the equity and bond markets often end up missing out on most of the gains. Don’t be one of them.

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Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2021.