Many people are under the misconception that their emergency fund has to be in a cash account. But, this is not true. Your emergency fund of three to six months of expenses has to be quickly liquefiable and readily accessible. A portion of your emergency fund should, without a doubt, be in a cash type of account such as a money market fund or a savings account that you have easy access to. But, a large bulk of your emergency fund can be earning you a little bit extra in interest.
The $3,000 Emergency Problem
The very first baby step in Dave Ramsey’s Total Money Makeover is to save $1,000 in the bank as a starter emergency fund. He believes that many of the problems that you will face in an emergency will cost on average $1,000 or less. All other large emergencies can be put on a payment plan and added to your debt snowball, but the $1,000 is designed to help people stop relying on credit cards in emergencies so they can dig themselves out of debt. Other people have suggested that $1,000 may be too low if you had a truly large ticket item. Maybe $3,000 is a better number to focus on as a starter savings account. This number could also serve as the backbone of your cash cushion in your emergency fund. If you have more than two or three months of living expenses available to you in cash, then you might have too much of your emergency fund languishing in cash. You could possibly put more of your emergency fund to work earning a few extra percentage points of interest with little extra risk.
Two Alternatives To Cash For Your Emergency Fund
Certificate of Deposit Ladder
If you are like my wife and feel comfortable only with a large safety net in place, then you may have upwards of twelve months or more of living expenses available to you in an emergency fund. While this is a nice luxury to have, that is too much of your nest egg that is tied up in cash and cash equivalent funds. A short term CD Ladder may be a good option for money that represents your seventh through twelfth month of expenses in your emergency fund. Every month, you could purchase a new one year maturity certificate of deposit. When one CD matured, you would reinvest that money into a new one year CD assuming that you did not need that money for a prolonged emergency.
Short Term Bond Funds
Short term bond funds can also be added to your emergency fund mix as a great alternative with a slightly stronger punch for the interest rate. Like with the CD Ladder, short term bond funds should not be used with the cash of your emergency fund that is needed for the immediate emergencies of life that should be funded with the three to six months of expenses that are invested in money market funds and in a savings account. Short term bond mutual funds that invest in short term government securities can provide a little bit more return for hardly any more capital risk thanks to the full backing of the United States government.
Believe it or not, but some people have too much of their net worth tied up in their emergency fund. Some investors have been so shell shocked after the recent fall of the stock market, that they are sitting on emergency funds that are too large and full of investments that are far too conservative. There are ways to continue to invest your emergency fund in safe investments while squeezing out a few more percentage points. Depending on the size of your nest egg, increasing your interest rate by a point or more can add real dividends.
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Another alternative is a Reward Checking account. They offer high rates than CDs, and are more liquid.
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