I always recommend having an emergency fund, which is three to six months of living expenses. Emergencies can happen at any time, and it’s not always a lost job. It could be that you’ve fallen ill or broken a bone that prevents you from working full time, or perhaps it is more cyclical, because when the economy slows down, so do your commissions. Regardless of how you use your emergency fund, the goal is to keep the money very liquid, so you can access it when you need it. You also want to preserve your purchasing power, so that the money beats inflation and covers your expenses in the future.
While short-term interest rates have increased, we’re still in a very low interest rate environment overall. Currently certificates of deposit (CDs) have some of the most attractive short-term rates with a one-year CD yielding around 2.5 percent. Generally, bank CDs are insured up to $250,000 per depositor per bank by the Federal Deposit Insurance Corporation (FDIC). However, CDs have an interest rate risk. If you only seek out the highest yields, you could lock up your money for several years, during which interest rates could increase.
Remember, the main goal for your emergency fund isn’t chasing the best yield but preserving the money so that it is there when you need it. If you have all your funds tied up in one-year CDs, you may have to sell one or more to access your money. We recommend laddering your CD purchases so that you frequently have a CD maturing. They can all be one-year CDs but if you have some due every few months some cash is always available. As the shorter-term CDs mature, you can take the proceeds and reinvest if you don’t need the funds.
While CDs may be somewhat liquid, there are other vehicles that may be more liquid, but offer lower interest rates. Money market deposit accounts with a bank are a type of savings account that often pay more in interest than a traditional savings account. They generally have higher minimum balance requirements and may limit the number of withdrawals per month. Like other deposit accounts offered by banks, a money market deposit account is generally FDIC insured for up to $250,000 per depositor, per insured bank for each account ownership category. Be careful here, as accounts in each account category are combined to determine your coverage. You can verify your coverage limits at www.FDIC.gov.
These deposit accounts should not be confused with a money market mutual fund, short-term investment products designed to be a low-risk, low-return investment, which intend to preserve your investment at $1 per share. The critical difference between the two is that money market mutual funds are not guaranteed by the FDIC or any other government agency. Furthermore, since the 2008 financial crisis, the government issued new rules that allow money market funds to “break the buck,” meaning the net asset value can fall below $1. Risk also varies amongst money market funds depending on their underlying assets. Some may invest in short-term U.S. Treasuries while others invest in commercial paper, short-term debt issued by companies.
Other options for short-term money include some exchange-traded funds that invest in short-term securities. Most, if not all, of the underlying assets are one- to three-month treasury-backed securities.
Just as you keep your investment portfolio diversified, you may want to keep your emergency fund diversified, ensuring your funds are liquid and perhaps protected with FDIC insurance.