What's the Difference Between an Emergency Fund and a Cash Cushion?
They're not the same thing!
Whether you call it a cash cushion or an emergency fund, having extra cash set aside can help you get out of some tough spots. However, each of these has its own use and you would likely need to have more money set aside for your emergency fund than for your cash cushion.
Understanding the purpose behind each type of savings can help you decide how much you need to put away for your own financial protection. Essentially, a cushion is a small balance ($100 - $1,000) that you maintain in your checking account for the sake of avoiding overdrafts.
An emergency fund is a large balance that you maintain in a savings account for the sake of bailing you out of a dire situation like a job loss. These are separate concepts; your cushion is not an emergency fund.
One of the top rules in personal finance is that you should maintain an emergency fund. Most emergency funds should be able to cover three to six months of living expenses. If you have an unsteady job in which your paycheck is highly dependent on commissions and bonuses, or if you’re a contractor or freelancer, or if you work in a shrinking industry, you may want to increase your fund to cover six to nine months of living expenses.
This fund should be used ONLY to pay for expenses that shock you. Things like a job loss, a hefty hospital bill, or a large veterinary bill for a healthy, one-year-old dog.
In other words, an emergency fund serves the purpose of covering unexpected expenses. Any costs that you can expect, such as car repair bills (every car will break down from time to time), should be paid from a savings fund specifically earmarked for that purpose.
Your Cash Cushion
A cash cushion is a balance of money that you keep in your savings account in order to protect yourself against insufficient-fund penalties and overdraft fees. Some people maintain a cushion that’s as small as $100; others feel secure when they have $1,000 stashed in their account. The less time you want to spend tracking your balances, the larger your cushion needs to be.
This cushion is your baseline checking account balance. Once your checking account dips below that cushion, you should mentally consider yourself to be “overdrawn.”
Of course, you’re not overdrawn in reality; you won’t bounce any checks or get hit with any insufficient fund penalties. But once you dip below your personal cash cushion, you should consider yourself to hold a balance of “zero” in your own mind.
Why You Need a Cash Cushion
As an example, let’s imagine that you have exactly $1,000 in your checking account.
On Monday, you write a check for $200, pay your credit card bill online for $400, and swipe your debit card to the tune of $400. By the end of the day on Monday, you have $1,000 worth of pending charges that will be deducted from your checking account.
Suppose that the $400 credit card bill payment and the $400 debit card payment both post on Tuesday. On Wednesday, you check your account and see that you still have a $200 balance.
Say that you’re a busy person with a lot of things on your mind, and you forget that you wrote a $200 check that’s still pending. You assume that the $200 in your checking account can be used, so you withdraw $40 from an ATM.
Later that same day, the bank tries to process the $200 check, but now you only have a balance of $160. In other words, you have insufficient funds. The check bounces and your bank charges you a $35 overdraft fee.
Keeping a Cash Cushion Can Help Your Finances
Using the same example as above, imagine that your cash cushion is $300. What would have happened?
If you had $1,000 in your account, you’d never make $1,000 worth of payments on Monday. You’d mentally imagine that your bank account only holds $700 since the other $300 is the untouchable cushion. You might have stopped yourself from buying something with your debit card that day.
If you did erroneously make $1,000 worth of payments on Monday, you’d notice your mistake upon checking your balance and seeing only $200 left in your account. That would set off an alarm in your head since that amount is less than your cushion. You wouldn’t withdraw more money from an ATM. Instead, you’d deposit money into your checking account as soon as possible, replenishing your cushion.