Jim usually writes at Blueprint for Financial Prosperity, please stop on by and check out his stuff!
With the economy showing weakness and the financial industry in tatters, a lot of people are feeling jittery about their future. One of the best things you can do to allay those fears is to prepare for the worst by starting or boosting your emergency fund. Your emergency fund is a sum of money you set aside to help against the worst, be it a medical emergency or the loss of a job.
The general consensus has always been to save about 6 – 12 months of expenses and label it your emergency fund. In these dark economy times, you might want to push that number up to 18 months, especially if job loss is a possibility for you. Having an emergency fund can help prevent you from falling into a downward spiral of credit card debt and financial ruin (the majority of bankruptcies were caused by medical bills!).
Emergency Fund Option Rules
How you come up with the money will be a test for you, but here are some suggestions for where to put it as you save. Rule number one when it comes to your emergency fund is capital preservation. It cannot, under any circumstances, lose money. Ever. That fund is there for emergencies only and you should never put it at risk. One day, if and when you need it, you have to be confident that it will still be there.
The second rule to emergency funds is that they must be easily accessible. If it takes more than a month get your money out, that’s far too long. I set a month at the maximum because you can always use a credit card to tide you over until you get access to the funds. The options I list below will all liquidate within a week or two.
A safe option available to everyone is an online high yield savings account. An online high yield savings account is a savings account that offers a high rate of return in return for your patience in working with a completely online system. The best ones have rates in the 3% range (currently) and they’re all FDIC insured up to $250,000 (until December 2009, then it’s back to $100,000). This is a competitive rate on a completely liquid account that you can access anytime without penalty. In return for this, you will have to contend with the prospect that there will often be no branch to visit and everything will be conducted online. When you compare it to typical bank savings rates under a percent, this is a no-brainer for a fund that you, hopefully, won’t need to access too often.
Certificates of Deposit (CD)
Another strategy is to use certificates of deposit. A certificate of deposit is a bank deposit product that has an interest rate that beats regular savings accounts. The trade-off with a CD is that you are “locked” into the product for the duration of its term. CDs come in a variety of term limits but the most common are in multiple of years (12-months, 24-months, up to 60- and 72- months). They aren’t completely locked though, you can often close a CD by paying a small interest penalty. The best CD rates are in the 4% range and, should you choose, you can always use a CD ladder to boost your emergency fund’s interest accrual rate (explained below).
Laddering CDs for your emergency fund is another popular option and it refers to buying CDs of different maturities such that one CD is maturing each month. Imagine the rungs on a ladder and each one being a CD. As each CD matures, you hold onto it for the month and then buy another CD at the end of the month. This keeps one month’s worth of expenses in your account while the remaining 11 are earning a higher interest rate. Some banks, such as ING Direct, even make it easy for you to set up a CD ladder.
If you’ve been thinking about where to put your emergency fund, I hope those three options are on your list.