An emergency fund is one of the single most important funds that contribute to your financial security, freedom, and independence. It is the key to the assurance that you will be covered in the future without digging yourself into a hole that could take you years to get out of.
But where to keep an emergency fund is the factor that determines its availability, liquidity, and growth potential.
So before we get into where it can go let’s go over the principles of an emergency which will explain why these places are a good place to keep your emergency fund in.
Principles of an Emergency Fund
Emergency funds have 4 main principles that ensure the fund’s maximum and full functionality:
- Must be liquid: When an account is liquid it means that you can easily turn that into cash whenever you need it. The point of the emergency fund is for you to use it on emergencies and emergencies are not foreseen. Thus, the emergency fund must be available to you on-demand for these kinds of circumstances.
- Must be insured: If the account that holds your fund goes completely out of business or bankrupt you need to make sure that you aren’t going to lose that money. You must make sure that your money is safe and insured in case anything like this were to happen.
- Must have low volatility: Some people don’t know what volatility means. This word is most commonly used when specifying the markets. It is simply the variety of fluctuations in the value of an asset. When something has low volatility, the possibilities of its value going up and down tremendously are very low. Since your emergency fund must be available for unforeseen circumstances, it is important that its funds are always available and that there is no chance of its value going down at any time.
- Must be growing: Though it’s very important to continue to fund your emergency fund even after you reach your fund goal, you should also ensure that the money is not just sitting there and losing value due to inflation. The average inflation rate in the US is 2% annually. This means that, on average, your money is losing 2% of its value every year if it’s not earning anything on its principal. You don’t want your emergency fund to be losing its power with every year that passes. This is why you must ensure that it goes into an account that pays interest on the principal value of your money.
Having these four characteristics in place ensures that your emergency fund’s effectiveness is fully maximized and that it will take you out of trouble whenever you need it.
Make sure not to use this for purchases on things that you don’t need… This fund is solely for emergencies ONLY.
Now, keeping all these principles in mind, where should your emergency fund go in order to follow these principles?
I’m glad you asked!
High Yield Savings Account
High yield savings accounts are one of the best places to keep your emergency fund in. A high yield savings account is simply a savings account within a bank (usually online bank) that pays you a high-interest rate based on the principal.
These rates vary (especially during the COVID-19 pandemic) and are subject to change at any time if the bank that holds the account finds it necessary to do so.
Typically, you will find these types of accounts within an online bank like Marcus by Goldman Sachs, Ally, or Citibank. There are plenty of other online banks out there that offer high yield savings, these are some of the most popular.
These are also insured by the Federal Deposit Insurance Corporation (FDIC), which means that if the bank goes bankrupt, the FDIC will back your money up with up to $250,000.
As said before, the yields of these banks can vary but it is worth noting that compared to your usual brick-&-mortar banks like Bank of America, Commerce Bank, or U.S. Bank the typical interest rate of high-yield savings accounts is several times higher.
Your typical brick-&-mortar bank will typically pay your account an interest rate of 0.01% or 0.02% and even when economic times are prosperous, they will still pay you very low rates compared to an online bank that typically pays around the 2% area, maybe more or less. Currently, they’re ranging in the 1% area because of the incredibly low-interest rates that the fed has placed on the nation.
However, despite this, online banks still manage to pay more than the 0.0% area that brick-&-mortar banks offer. One of the biggest reasons why they’re able to do this is because since everything is online, they have no overhead costs that their money has to go into.
Thus, they’re able to give more back to you on your principal.
Also, not as common, but some banks and brokerage companies are starting to offer debit card services on their savings accounts. Wealthfront and Robinhood are excellent examples of this, the best part about these is, they don’t charge for these services and they pay you interest for simply having your money in their accounts.
This isn’t as common and I don’t recommend keeping an emergency fund in a place like Robinhood either, it was simply an example of a brokerage who does that.
Certificates of Deposit (CDs)
CDs are accounts in which you can keep your money locked on a specific interest rate despite what the interest rates do nationally. If you keep your money in a 5-year CD at 3%, it will keep that interest rate locked into that account even if interest rates go down.
The plus side is that these accounts typically have higher interest rates than high-yield savings accounts and money market accounts (discussed in the next section).
Some CDs have a minimum deposit amount that must go into an account to open it.
They are also FDIC insured because they are offered by banks themselves, again, if the bank goes bankrupt you have $250,000 worth of money completely backed up by the FDIC.
Unfortunately, most CDs also lock your money down with it and if you want to withdraw it before its term ends then they might charge a penalty fee for early withdrawal. Not all CDs have this flaw though, some CDs have no early withdrawal penalty but typically these pay a lower interest rate than those with penalties.
If you really want to keep your money in a CD, consider using a CD ladder. Which is when you keep different portions of your money in different CDs with varying rates and term lengths. This way, if you need your money in a situation, you have some of it available without any penalties.
Money Market Account
Money market accounts have similarities to both, high yield savings accounts and CDs.
The similarity they share with CDs is that they usually have a minimum deposit amount but they relate to savings accounts in their similar interest rates and they don’t lock your money for a predefined term.
However, money market accounts usually tend to charge fees that are not charged within CDs or savings accounts.
Different money market accounts have different rules when it comes to minimum deposits and fees. But it is worth noting that several money market accounts offer check-writing and debit card capabilities which is a very common plus!
These accounts are also backed depending on the issuer. If it’s a bank, it is FDIC insured, if it’s a credit union then it is backed by the National Credit Union Association (NCUA).
As said earlier, these accounts have check-writing features debit card features but they have varying rules to how you can use these features.
You are not allowed to withdraw money or make payments more than six times per month by check, debit card, or electronic transfer.
Withdrawals or payments made by ATM, in person, by mail, or any other format in which your account and routing number are used don’t count against the six-transaction limit.
It’s important to stay informed on these rules, the minimums, and the fees before choosing a money market account if this is the route you choose to go.
Treasury Bills (T-Bills)
Finally, a more uncommon place to keep your emergency fund in is a T-bill. By “placing” I actually mean “purchasing”. But don’t be alarmed, these bills are purchased at a value lower than their face value and can be sold at the maturity date.
T-bills are a short-term debt obligation backed by the U.S. Treasury Department with a maturity-terms of a few days to one year. They are basically a bond, except they are not a bond for a company but a bond for the government.
The longer the maturity date, the higher the interest rate that the T-Bill will pay to the investor.
By this date, the value of your money has gone up and you’ve effectively earned interest on your money. For example, a $1,000 bill might cost the investor $950 to buy. By the time the bill hits its maturity date, it will be at $1,000.
If a T-bill is sold early, there could be a gain or loss depending on where prices are trading at the time of the sale. In other words, if sold early, the sale price of the T-bill could be lower than the original purchase price.
It’s a bit of a risk to run but they are still considered low volatility.
These accounts are also tax-advantaged in a variety of ways depending on the bill.
Currently, T-Bills don’t give a yield as high as the accounts listed above and don’t offer FDIC or NCUA insurance but they are backed by the full faith and credit of the U.S. government. Typically, anything backed by the U.S. government is considered to be the safest form of investment.
It is important to note that these accounts all have their own advantages and disadvantages, just know that nothing stops you from using all of them, though not the most ideal plan.
Keep in mind (excluding t-bill tax advantages) interest earned is taxed as income during tax season and it is important to keep in mind that some of that interest payment will be going to good old Uncle Sam.
Regardless, these options are all great options to keep your money in, depending on your individual circumstances, some may be more beneficial than others. Once you decide which type of account works best, do your research to know which issuer will be of greatest benefit to you.
Now, your emergency fund will work for you and will also be available to you when you need it. If you have any questions on what I’ve mentioned in this article please comment below, I’ll be gladly responding to each and every one of you!