One thing that happens to almost everyone at some point during their financial growth is that they wind up with some significant amount of idle cash on their hands. Sometimes it simply happens as a result of becoming more frugal while also keeping an eye on spending, such that the person is spending a lot less than they earn and thus their checking account is growing each month. Sometimes, it happens due to windfalls that a person is unsure what to do with, so they just stick them in the bank and plan on worrying about it later. There are lots of reasonable explanations for why this can happen, and it often does happen when people start being more aware of their finances. The question then becomes, now what?
To be clear, when I talk about idle cash, I mean money that’s sitting in a bank account without any real intended purpose. An emergency fund is actually an intended purpose for money sitting in a bank account. If you have money in your savings account that’s set aside strictly to help in emergency situations, that’s not idle cash at all.
It starts with your goals.
The reason that truly idle cash is bad is that it is doing a pretty poor job of helping you achieve any goals in life. Almost everyone has some kind of goal in life-related to their finances, whether it’s simply to retire without a threadbare existence, to pay off all of one’s debt, to buy a home – whatever it might be. Idle cash is cash that you have that isn’t working toward any goal.
So, the first thing you should always ask yourself when you have idle cash on hand is what your goals in life are. I think that most people have at least two financially related life goals – getting rid of their debts and making sure that they’re not threadbare in their later years. Aside from that, there are lots of potential goals people might have: making a career change or owning a home or buying a car or running for Congress. All of those goals have different strategies, so we’ll focus on a few of the more popular ones.
If you don’t have any other goals, aim to pay off your debt, starting with high interest debt.
For example, if you have credit card debt still outstanding from your earlier days of overspending, get rid of that credit card debt. No matter what might come along in the future, you’ll almost never regret this. Getting rid of debt that’s accumulating interest at a rate of 20% to 30% per year is virtually always a wise move.
In general, it’s a good idea to get rid of any debt with a high interest rate. I personally define “high interest” as anything over about 6% right now, though that number can change over time. This might include things like student loans, car loans, personal loans, or any other type of debt. Generally, right now, this doesn’t include mortgages.
Putting that idle cash toward your highest interest debt is great, but first, see if you can reduce some of those interest rates. Can you transfer a credit card balance with a zero-interest transfer offer? Can you refinance your student loans or your mortgage? If those steps can lower your interest rate, do those things first, then use your spare cash to pay down your highest interest rate debt.
If you don’t have any other goals and don’t have any high interest debt, put some money aside for retirement.
You don’t need a workplace that offers a retirement plan to save for retirement. Anyone can do it. All you need is to set up an individual retirement account with a financial institution that offers it, and many do. I personally use Vanguard for mine; Fidelity and Schwab offer good options, too.
If you earn less than $120,000 per year (this number gradually goes up over time, so you’ll want to look into this carefully if you’re interested in this option), the best individual retirement account available to you is a Roth IRA. With a Roth IRA, you deposit money into the account (just like a bank account) and decide within the account how you want the money invested. If you’re unsure, there are a lot of very good simple options — I usually encourage people to choose a Target Retirement Fund that matches the year they want to retire.
Then, you just let it sit there and grow. You can withdraw what you contributed at any time without penalty; if you wait until you’re in your 60s, you can withdraw all of the gains as well without penalty or taxes. That’s right, a Roth IRA lets you grow money for retirement without paying any taxes on it as long as you actually use those gains when you’re of retirement age.
(For those earning more than $120,000 a year, you should look at a traditional IRA as another option; it has different tax implications but it’s also an account you can easily open for yourself.)
If you want to own a home in the next several years, start saving for a down payment.
The advantages of saving for a house down payment if you are planning to buy a home are many. A down payment improves your chances of getting a good mortgage offer, and a large enough down payment means that you won’t have to buy mortgage insurance (typically, you need a 20% down payment to avoid it entirely). Furthermore, the larger your down payment, the smaller your mortgage, which means smaller house payments and less interest paid when you do buy.
Here’s a good general strategy: if you’re saving for a goal that’s coming up within the next few years, you should do it in something very safe that will generate a small return but won’t lose value. If you’re saving for a house down payment, for example, and hope to buy within five years, a year like 2008 in the stock market can wreck your plans if that’s where your money is invested.
So, what does that mean if you’re saving for a house down payment? You should keep that money in something safe like a money market account or a certificate of deposit or even an ordinary savings account if you’re getting close to buying.
A money market account is a type of account offered by many banks that offers a better return than most ordinary savings accounts, but is similarly safe. The return can vary a little bit, but it’s usually somewhere between 0.5% and 3%, though it can drop to 0% occasionally. It’s FDIC-insured, which means that up to $250,000 of the money is guaranteed against the bank failing (just keep your records). The disadvantage is that you’re restricted in terms of how often you can withdraw money, but if you’re just saving for one big expense, it’s not an issue. Some money market accounts will have a minimum balance, too, so if you’re not there, just use an ordinary savings account until you are.
A certificate of deposit is basically an agreement with a bank, where you agree to give them a certain amount of money for a certain amount of time without touching it, but during that time, it earns a better interest rate than normal savings accounts and usually even outpaces money market accounts, although it’s still less than risky investments. This is also FDIC insured, as described above. However, the drawback is that you can’t touch the money until the end of the agreement without paying a penalty. It just sits there until it matures, at which point the money is usually just put into your checking account or savings account. If you’re going to put your money into a certificate of deposit from your bank, choose one with a timeframe that’s shorter than the number of months or years until you’ll need that money.
An ordinary savings account is like a money market account, except the interest rate is usually very stable and at the lower end of the money market account range, but it rarely varies. It’s a good place to put money if you’re getting very close to using it.
I highly encourage people who are saving for a specific non-retirement and non-educational goal in the next several years to strongly consider one of these options.
If you want to buy a car in the next few years, save for a car down payment.
Saving for a car down payment means that, when you buy, you’ll get a smaller car loan. Because you’re borrowing a smaller overall amount, you may be able to get a shorter term loan with a much lower interest rate with monthly payments you can still handle, which will end up saving you a lot of money.
The same exact advice applies to saving for a car down payment as it does for saving for a house down payment. You want your money in something quite low risk, because you don’t want that money vanishing due to a big dip in the stock market and there won’t be time to recover before you need that cash.
It always comes back to goals.
The best thing to do with idle cash depends entirely on what you want out of life. Are you pretty content with things and just want a more comfortable and secure retirement? That points you toward a different savings strategy than if you want a home loan in three years, which is in turn different than if you need a car loan in a few months.
Figure out what it is that you want to do, then use your idle cash to move toward that goal. You’ll make much faster progress if you use your money in a way that’s in line with what you want.