We all know the value of an emergency fund. With several months’ worth of expenses in the bank, we get some level of security and can handle unexpected expenses. In fact, the first step in achieving a higher level of financial freedom is moving away from living paycheck to paycheck.
The big question is where to keep your emergency fund. For many the first option is a savings account. While you can find some high interest savings account options online, the best rates currently top out at less than 1.5%. While that is certainly better than stuffing the money in your mattress, it’s still pretty low. The good news is that there is an excellent alternative—a long-term certificate of deposit.
A five-year CD, for example, currently pays around 3.0% interest. This rate is much higher than anything available from a savings, checking, or money market account. And with some of the best CD rates available online, it’s extremely easy to open an account. But the reality is that most people do not put their emergency fund in a long-term CD. Why?
There are two reasons. First, folks are rightly concerned about the interest penalties they will pay if they need to take out their money before the CD matures. This is a valid concern as some CDs charge as much as 6-months’ worth of interest for an early withdrawal. And second, many are concerned that interest rates will rise during the term of the CD, and they will be stuck with a long-term investment at a lower rate.
The good news is that there is a way to address both of these concerns. It turns out that some long-term certificates of deposit charge a relatively low penalty for early withdrawal. The best example comes from Ally Bank. Not only does Ally offer some of the best CD rates available (its 5-year CD currently pays about 3%), but its penalty for early withdrawal is just 2-months worth of interest.
So how does this long-term CD compare to a savings account? Let’s compare a high interest savings account paying 1.40% APY with a long-term CD paying 3.0% APY and charging a 2-month interest penalty for early withdrawal. And let’s assume that after 12 months, an emergency comes up (or interest rates rise) and you need to withdrawal all of your money from the account. With the savings account, you would have earned 1.40% before taxes. With the CD, you would have earned 3.0% less two months worth of interest (about 0.50%), for a total return of about 2.5%. The CD wins!
About the only time a long-term CD with a low penalty rate wouldn’t beat a savings account is if you need the money immediately after opening the account. If that’s a concern, you can always split your emergency fund, placing a portion of it in a savings account and the rest in a CD. So with a little creativity and effort, you can put your emergency fund to work earning more interest than you would get from a savings account.
This post comes from DR, the founder of the Dough Roller, a personal finance and investing blog.