Since the financial crisis of ‘07-’08, interest rates have been so low that we have forgotten what it was like to earn a noticeable yield in a bank account. Because inflation has forced the Fed to raise rates over the past year at a historic pace, we are now seeing some of the highest yields on FDIC insured accounts in decades.
For the same reasons, we have seen a spike in yields across many different “safe” cash equivalent options like CDs, Treasuries and Money Market Funds. Today, I will discuss how we should rethink our approach to an emergency fund, four great places to save the funds, and the pros and cons of each.
Emergency Fund: What It Is and How to Start One
One of the most important parts of a strong financial plan is establishing an emergency fund. Households should maintain a certain level of cash or a liquid cash equivalent to cover any unforeseen expenses, like being laid off from a job or a car breaking down.
Some of the factors to consider when determining the appropriate level of cash to stash away include:
- The security you feel in your current employment.
- The length of time it would take you to get a new job in the event you are laid off.
- Your current household expenses.
The rule of thumb for establishing the level of funds to put aside is 3-6 months of household expenses.
For example, if your household expenses are $5,000 a month, you’d want to have about $15,000 – $30,000 of funds put aside in an emergency fund. If you feel very secure in your current employment and believe you’d get a job pretty quickly in the event you were laid off, you might be comfortable with $15,000. On the other hand, if you felt insecure and your job search could take a while, you might want to consider an emergency fund that’s closer to $30,000.
An emergency fund is also important to the mentality of investing. Assuming the risk level of your portfolio is inline with your risk tolerance, a healthy emergency fund will help you mentally cope with the inevitable ups and downs of the markets.
Knowing you have enough cash to weather a storm will help you avoid costly emotional mistakes. Ultimately, you want to be in position to comfortably invest anything beyond the amount you have in your emergency funds.
4 Places to Stash Your Emergency Fund Savings
Now that you’ve established a comfortable emergency fund level, it’s time to consider where to safely save it. Here are four great places to keep your funds safe while reaping the benefits of higher interest rates.
High-Yield Savings Accounts
Not every savings account is created equal. If you have a savings account at one of the “big banks,” like Chase or Wells Fargo, you may have noticed that you’re earning next to nothing by holding cash in those accounts. These banks are not in the business of high-yield savings accounts. They are retail banks that do certain things well – like offering the convenience of brick and mortar locations, technology and customer service.
Online banks like Ally, Capital One and Marcus offer high-yield savings accounts because they don’t have retail locations (for the most part), and in turn have much lower overhead costs.
As I write this today, high-yield savings accounts have an APY of about 3.5-4.0%. These accounts still reap the benefit of being FDIC insured, which means they are insured up to a deposit of $250,000. They don’t have the accessibility of withdrawals like a checking account would, but they are typically easily connected to your checking account for transfers.
One of the things to be aware of as you shop around is that banks will lure you in with what appears to be much higher yields than other banks, then drop them with very little or no warning. So, you will need to stay on top of the movement of the rates.
Money Market Mutual Funds
Money Market Mutual Funds are mutual funds that you can purchase in a taxable brokerage account that earn yields very similar to high-yield savings accounts.
These are not FDIC insured, so you should look for funds managed by larger institutions like Schwab or JP Morgan.
If you already have an individual or joint account, these can be easily managed within those existing accounts by simply purchasing the amount of emergency fund you would like to keep in one of these funds.
The US Department of the Treasury issues debt obligations with maturities of four weeks up to 30 years. Typically, the longer maturities would be yielding high rates, but because of the rising interest rate environment and interest rate risk, Treasury Bills with maturities of 4, 8, 13, 26, and 52 weeks have the best yields. In fact, the three-month and four-month maturities have a yield of about 5.2%. These are backed by the US government and considered extremely safe.
The downside of treasuries is you need to hold them to maturity to assure you receive the maximum yield. Treasury Bills are sold in denominations of $1,000, and unlike the other treasury debt obligations, they do not pay an interest rate or a coupon rate. Your yield will be derived from the discount you buy them. The lower the price you pay below $1,000, the higher the yield. At maturity you will receive $1,000 so the difference between what you paid and $1,000 is your yield. Although treasuries are completely liquid, you could lose some of your yield if you need to liquidate them early.
If you decide to go in this direction, you would need to set up an account with the treasury department at treasurydirect.gov.
A CD, or Certificate of Deposit, is a savings account that holds a fixed amount of money for a fixed period of time, such as six months, one year, or five years, and in exchange, the issuing bank pays interest.
Because you sacrifice liquidity over these periods of time, you will see higher rates of return as compared to high-yield savings accounts that have complete liquidity.
The main con here is that you do not have access to the funds, and there is a withdrawal penalty, which varies. These are currently getting a yield of about 5-5.1% for a 6 month to a year period, respectively.
Related: How Much Cash Should You Keep In the Bank?
If you have questions about anything I discussed, or would like to speak to our team about your current financial situation, you’re welcome to schedule a complimentary consultation below. We’d be happy to help!