Most financial advisors can agree on one money principle: Having an emergency fund—equal to at least three to six months of expenses. But where should you keep the money that is safe from a volatile economy, but could earn interest to beat—or at least meet—inflation?
The most common options are savings accounts, money market funds and certificates of deposit (CDs). But like all financial products, there are pros and cons to each. Here’s how they stack up.
Advantages: An online savings account is a safe, smart option for an emergency fund. It requires little effort to maintain; is insured by the Federal Deposit Insurance Corporation (FDIC) for up to $250,000 per depositor per bank; and the funds can be accessed within a day or two when necessary.
A high-yield savings account is completely liquid, carries zero risk of losing value, and has competitive rates, currently between 1.50% and 1.85%, says Mark D. Beaver, a financial advisor at Keeler & Nadler Financial Planning and Wealth Management in Dublin, Ohio.
“Many of the online banks are raising their rates frequently as well to keep up with the current rate environment,” Beaver says. “It’s a boring solution, but it’s better to be boring with an emergency fund. It’s not meant to be an investment.”
Disadvantages: Be sure to read the fine print. Some accounts charge a fee if you don’t keep a high minimum balance. Other savings accounts might offer an attractive rate, then cut it a few months later after you open the account.
Pro tip: Keep the emergency savings account separate from a day-to-day account—even at a different bank—to avoid accidentally spending the money on a non-emergency.
Money market fund
Advantages: Money market accounts offer yields that are similar to savings accounts. They’re easy to use and since you can withdraw your funds at any time, they can be another option for your emergency savings.
Beaver says money market accounts are “very liquid” with “generally no risk of losses.” Rates range from 1 percent to 1.75 percent, not any higher than some of the online savings accounts.
Disadvantages: A money market fund has expenses that eat into the amount of interest earned. Plus, there is an element of risk involved because money market funds are not insured by the FDIC.
Pro tip: If you’re leaning toward a money market fund, consider buying Treasury bills directly via Treasury Direct instead, says Thomas Yorke, managing director at New Jersey-based Oceanic Capital Management. These accounts link to your checking or savings account for reinvestment purposes. But if you need cash quickly, you can sell the bills with no early withdrawal penalties and credit your checking account the next day.
“Treasury bills don’t quite pay what secondary certificates of deposit (CDs) pay, but you don’t have issuer risk,” Yorke says. “Even though [banks] have FDIC Insurance, getting things straightened out after an FDIC takeover might mean a delay in accessing your money.”
CDs, preferably with laddering
Advantages: CDs offer a fixed rate of return for a specific length of time. Since your return is guaranteed, opening a CD could be a way to earn extra interest on your emergency fund.
CDs can also be attractive when you open multiple CDs with different maturity dates—such as every quarter. This is called laddering and means you can predict when a certain amount of cash available will become available when the CD matures.
Disadvantages: There’s a reason why it’s called emergency savings: You don’t know when an emergency will occur. If you need to cash out before the CD matures, you will likely pay a penalty, says Juan Ros, a financial planner with Lamia Financial Group.
For example, Capital One charges three months of interest if you redeem a CD with a 12-month or shorter term before it matures. For a longer term, the penalty jumps to six months of interest. Interest on a typical one-year CD is around 2%, so the early withdrawal penalty for a Capital One CD would be about 0.5%.
“The slightly higher interest rate you would get with a CD is not worth the restriction on your money in the event of an emergency” Ros says. “The goal is for your emergency money to be protected and easily accessible if and when you need it.”
Pro tip: Some banks—such as CIT Bank and Ally Bank—offer risk-free CDs that allow early withdrawals without penalty. The rates are competitive, too, so you’re not sacrificing on returns. Other banks allow loans against CDS, which may be cheaper than withdrawing funds early, depending on the bank’s terms.