Whether it's a "cash cushion" or an "emergency fund," having extra cash set aside can help you get out of some tough spots. However, both cash cushions and emergency funds have their own uses, so it's important to maintain both. Understanding their unique purposes can help you decide how much you need to put away for financial protection.
In general, a cushion is a small balance (less than $1,000) that you maintain in your checking account for the sake of avoiding overdrafts. An emergency fund, on the other hand, is a large balance that's meant to sustain your living expenses for months after a major event like job loss or a medical emergency.
Keep reading for more on the differences between these two funds and why they're both important.
One of the top rules in personal finance is that you should maintain an emergency fund. Depending on who you ask, you may get a different answer as to the size of an emergency fund. In general, stowing away three months' worth of living expenses is a good place to start. Freelancers, contractors, and people whose income depends on commissions and bonuses may want to save more in an emergency fund to make up for that irregular income.
This fund should be used only to pay for expenses that shock you. Any costs that you can expect, such as vacations or car repair bills (any car will occasionally require repairs), should be paid from a savings fund specifically earmarked for that purpose.
Emergency funds are important because some negative financial events are completely out of your control. No one can precisely predict a recession, or when a company is going to lay off workers en masse. No matter what happens, or why it happens, an emergency fund will give you time to get back on your feet without having to worry about how you'll eat or pay rent.
Your Cash Cushion
A cash cushion is a balance of money that you keep in your checking account to protect yourself against insufficient-fund penalties and overdraft fees. The appropriate size of a cash cushion depends on your spending habits. If you carefully track your balances, expenses, and income, you may only need an extra $100 in your checking account. If you only occasionally check your accounts, it may be wise to keep as much as $1,000 in a checking account as a buffer.
This cushion is your baseline checking account balance. Once your checking account dips below that cushion, you should mentally consider yourself to be “overdrawn.”
Closely track and quickly replenish your cash cushion to help prevent yourself from overdrawing on your account for real.
Why You Need a Cash Cushion: An Example
As an example, let’s imagine a situation both with and without a cash cushion.
Without a Cash Cushion
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 have a $200 balance. You’re a busy person with a lot of things on your mind, so 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.
With a Cash Cushion
Stick with the same example as above, but now imagine that you maintain a $300 cash cushion in your checking account. If you had $1,000 in your account, you’d never make $1,000 worth of payments on Monday, because that would deplete your cash cushion. You’d mentally imagine that your bank account only holds $700—the other $300 is the untouchable cushion. You might have stopped yourself from buying something with your debit card that day.
Even if you did erroneously make $1,000 worth of payments on Monday, you’d notice your mistake upon checking your balance Wednesday and seeing only $200 left in your account. That would set off an alarm in your head, and you wouldn't withdraw any more money until you replenish your cash cushion. Instead of withdrawing $40 from an ATM on Wednesday, you might deposit money into your checking account.