For a lot of us, our emergency fund is a big sum of cash. It's sitting in our bank accounts, tempting us to use it. It's not doing anything for us. It's not invested or getting us "fun" things. It's just dormant money waiting to become active for an emergency. Why not put that dormant money to use?
Well, there's a pretty good reason not to put an emergency fund to use. It's your security. You don't want to risk losing it. You need it for the hardest of times, but the problem is even though you're not using it, you're still losing money. How? Well, inflation. If you look at inflation between now and 1958, you'll find that the average inflation is 3.68% per year. In other words, money you don't spend loses 3.68% per year. Explained again, if you had $1000 on January 1st, by December 31 it would be like having $963.20. It's crazy to think about, but even though you didn't spend ANYTHING, you still lost almost $40.
So, what's the solution? This is how I look at it. I need to earn 3.68% on my emergency fund per year, just to keep it in line with inflation. Secondly, I want to do it with as little risk as possible. So to recap:
So, the solution is to invest your emergency fund just enough to earn 3.68% on it. The worst thing you could do is just place it in the stock market though, even in low risk index funds or mutual funds.
Imagine this scenario. You invested your emergency fund in some low risk funds, earning a modest 4% per year. The market crashes and you lose your job, but since the market crashed you also lost 40% on your emergency fund. Now, when you needed it the most, it's worth almost half of what it originally was. Now you probably see the risk.
Thankfully, there are some low risk solutions that might work for you. Here's my review, pros and cons, of each. Like with many of my posts, ultimately it's up to you and its different for everyone. The amount of risk you're willing to take, your likelihood of needing emergency money, and how important it is to you, are all are factors of this decision. I think it could be different for everyone.
Let's get started reviewing some good low-risk investment options for your emergency fund...
Savings accounts are most likely what you are keeping your emergency fund in now. It's perhaps the lowest risk, but also offers the lowest return on your money. Most banks offer less than .1%, which isn't even worth considering. There are some banks out there that offer more. For example, Ally Bank is offering a savings account at 2.1%. That might be enough for you. Then you'll only lose about 1.5% on your money per year, or about $15 per $1000 in your emergency fund.
If you're likely to experience an emergency, or don't like high risk investments, a savings account is best for you. The con, I haven't found a savings account that could keep up with inflation, so you will definitely be losing some money every year.
I will say, if you can find a bank that offers a savings account at 3.68% or higher, please let me know! Let's say "Better Budget Bank" offers a savings rate of 3.7%, I would say this is the best option for your emergency fund right now. I wouldn't even review other options.
CDs (Certificates of Deposit)
CDs might be an okay option. The problem with CDs + emergency funds is that they lock down your money. It keeps your money from being liquid. One of the things about emergency funds is that you don't know when an emergency is going to occur. So, if your entire emergency fund is locked up in a CD, then you might have to pay penalties when you take it out (if you take it out before maturity).
Another con of CDs, at least at the time of this posting, is the best 1 year rate is 2.7%. The best 5 year rate is 2.8%. Neither get you to our inflation goal of 3.68%. Similarly, if you just did a high-interest savings account for somewhere in the low 2s%, then it would be a lower risk because you keep your money liquid.
Well, let's say you read this at a different time and CDs are around 4%. So, at this point, I would consider CDs as an option for my emergency fund. Next, I would ask myself how likely I am to have to pay for an emergency and if I can wait for a CD to mature. My biggest emergency over the past couple years has only been about $1000. Additionally, I usually have enough in the bank to cover this sort of emergency. I'm in a stable job and have a strong family that would support me in the worst-cases. My need for very liquid money is low, which suggests CDs might be a good option.
Let's say everything checks off and you believe CDs are the best route for you. This is how I believe you should use CDs for your emergency fund. You want to set-up a 5 year CD ladder. You can Google "CD ladders" and get a in-depth explanation, but here's how they work at a high-level by example.
Say you have a $5000 emergency fund. You divide your emergency fund by 5, to get $1000. Then, you invest invest $1000 is a 1 year CD, 2 year CD, 3, 4, and 5 year CD. Now, you have 5 CDs, which matures once per year. If you think you could experience emergencies more frequently, buy more CDs at smaller, equal, intervals. Then, when one CD matures, reimburse yourself for an emergency, or reinvest into a 5 year CD again.
To be honest, I haven't done too much with treasury securities. I tend to have a stock-heavy portfolio and thus, don't purchase many treasury securities. Treasury securities can be bought directly from Treasury Direct. The advantage is the low risk. They're backed by the US government, so you know they lower risk in that sense. However, they lock up your money like a CD. Unfortunately, they don't pay much more than CDs either. There are some long term 30 year bond options that out perform inflation, but 30 year options are not good for an emergency fund.
If you are happy with treasury securities as an option for your emergency fund and are happy with the risk tolerance, I would still really encourage you to ladder your investments. You don't want your emergency fund being tied up when you need it most.
I would personally not recommend treasury securities. I think there are better options, but this may be due to my lack-of experience with treasury securities. I don't like putting my emergency fund in places that are influenced heavily by market conditions (and in this case, political conditions as well). Likewise, you can earn more on your money, in shorter periods of times, using other options. Lastly, I'm not a huge fan of having an not-liquid emergency fund. So, securities and CDs aren't my favorite choices.
Money Market Accounts
Money market accounts are similar to high-yield savings accounts. One of the biggest differences is that money market accounts usually require a minimum amount for their rates. For someone growing an emergency fund, or just have low expenses so, thus, a low emergency fund, a money market account might not be best.
While this might be a con to some, it might be a good thing for an emergency fund. Money market accounts often have a transaction limit. If you're one that finds yourself always dipping into your emergency fund, this might be a great option for you.
Overall, I think money market accounts are second to high-yield savings accounts. If you can meet the minimum requirement, they're great. They're highly liquid too. The con, in today's market, they still don't offer that 3.68% return rate we're looking for. They're usually better than high-interest savings funds, but they're still only in the mid-twos. About a percent off or so, from where we want to be.
This is kind of a broad topic, but I think they can all be considered similarly. I think this is the riskiest option, but I also think it will get you closest to that 3.68%. Look at all different types of funds, mutual funds, index funds, etc. and find one that you're comfortable with. When I say comfortable, I mean to make sure it fits within your risk tolerance.
I recommend you only invest in funds if you meet the following criteria:
This post was long, but I think it had a lot of great information in it. My favorite option is probably just a high-yield savings account. Money market accounts are great, but I don't have a large enough emergency fund yet for a lot of them. CDs and securities are not my favorite options, because they tie up your money. I like funds, but I haven't been able to find a fund that would fit within my risk tolerance. You could also do do a combination of these options.
Ultimately, the decision is whatever fits your finances best. Think about your life, your emergencies, and your risk tolerance. Then, make a decision to see where the best place is for your emergency fund. You may be okay with a 3.68% loss and just keep it in a standard, every-day, savings account. That's totally okay, because it's your emergency fund and it fits your risk tolerance. The important part is that you have it when you need it most.
If you made it this far, I'm really happy you took the time to read. I hope you learned a little, or a lot, or just enjoyed finding all my grammar mistakes. If I can help you make a decision on where to put your emergency fund, please ask. I haven't heard from many of you yet, but I know you're out there. Don't be shy!
Thanks for reading the Better Budget Blog and I hope this helps you get better with personal finances everyday.
Better Budget Co
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My name is Corey and I have a passion for budgets and personal financing. I can talk about it for days (weirdly enough). Hope you enjoy the blog!
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