Everyone should have an emergency fund to draw from when they’re hit by a surprise expense or a job loss.
Since you never know when you’ll need to draw from the emergency fund, you want your emergency fund to be stable and safe. Stocks and stock mutual funds don’t meet this requirement, and that becomes apparent during times of stock market volatility.
When the stock market plummeted in 2008, millions lost their jobs. Those who had stocks in their emergency funds during that time and needed the funds to pay bills may have been forced to sell their stocks at a significant loss.
[See: 13 Ways to Take the Emotions Out of Investing.]
A deposit account satisfies the safe and stable requirement. Deposit accounts from banks and credit unions are federally insured. As long as your deposits at any one bank are under the FDIC coverage limits, you are guaranteed not to lose principal or interest if the bank fails.
To maximize your yield on a deposit account, certificates of deposit can be used. The interest rate of a CD is typically much higher than savings and money market rates. For example, the average savings account rate is less than one-eighth the average rate for five-year CDs.
Even though CDs are stable and safe, accessing CDs before maturity is an issue that complicates using them in an emergency fund. CDs typically have early withdrawal penalties that are charged when you withdraw principal before maturity. Those penalties can eat into both the interest and the principal of your CD.
An early withdrawal penalty doesn’t mean you should entirely avoid CDs for your emergency fund. There are steps you can take to reduce the chance that you’ll lose money when you access an emergency fund that holds CDs.
First, it’s wise to have at least some of your emergency fund in a savings or money market account that’s immediately accessible without any penalties. It’s rare to need your entire emergency fund immediately. For cases like a job loss, only a portion of the emergency fund will be needed early.
[See: 9 Psychological Biases That Hurt Investors.]
Second, ladder the CDs so that you won’t have to wait too long for one of your CDs to mature. A CD ladder allows you to invest in longer-term CDs, which typically offer higher rates than shorter-term CDs. Instead of investing in just one long-term CD, open multiple CDs so that CDs will mature at regular intervals.
Third, ensure that the bank or credit union has policies that allow quick access to CD funds. When you close the CD, will the bank quickly transfer the CD funds to your checking account? Or will they mail you a check that could take one or more weeks to arrive? This is important whether the CD is closed early or at maturity.
Fourth, choose CDs with mild early withdrawal penalties. Penalties vary greatly. Look for penalties of no more than six months of interest for terms of three or more years. For terms under three years, look for penalties of no more than three months of interest.
Lastly, choose a bank that offers ways to access some of the CD funds early without a penalty. Make sure the bank allows for a penalty-free withdrawal of all interest that has accrued. Also, look for banks that allow partial early withdrawals. The penalty will only be applied to the portion of the principal withdrawn. The rest of the principal can remain in the CD.
Being able to access some of the CD can be useful if you need money to pay for those unexpected bills.
[See: 10 Tips for Couples and Young Families to Build Wealth.]
By holding CDs in your emergency fund, you can earn significantly more than by holding just a savings or money market account. That higher return does have a cost, but with careful planning and CD shopping, you can ensure you maintain quick access to most of the funds without harsh penalties.
More from U.S. News
11 Steps to Make a Million With Your 401k
7 of the Best Stocks to Buy for 2018
20 Awesome Dividend Stocks for Guaranteed Income
Investors Need an Emergency Fund More Than Ever originally appeared on usnews.com
