In our last blog post, we established the need for having some extra cash outside your investment portfolio for life’s unpleasant surprises. The reason being, should you encounter a financial emergency at the same time as your investment portfolio is declining, this can have a lasting impact on an investor’s overall wealth and potentially derail their financial plan. As we stated in our last blog post, you should aim to have at least 3 to 6 months of expenses in an emergency fund, outside of your investment portfolio. Now that we have established the need for an emergency fund, the question becomes where do we ‘stash this cash’?
We want to lay out a few common emergency fund vehicles along with their advantages and disadvantages. We always recommend considering liquidity, safety, interest rates, and potential fees and other restrictions when choosing your emergency fund vehicle. Again, the specific choice will depend on your situation and financial needs.
Checking Accounts: everyone is familiar with a checking account. This is a deposit account held at a financial institution that allows for deposits and withdraws on demand. Checking accounts are generally very liquid but typically pay little to no interest.
- Advantages: the primary advantage of checking accounts is their liquidity and the fact that banks usually do not limit the number of transactions every month. Checking accounts also qualify for FDIC insurance, up to certain limits.
- Disadvantages: the primary disadvantage is that checking accounts earn little to no interest unless you maintain a larger balance with the bank. Also, being able to withdraw funds on an instance with little to no limitation on the number of transactions may entice you to spend the funds rather than keep them aside for an emergency.
Savings Account: Interest-bearing deposit account held at a bank, similar to a checking account. However, savings accounts normally pay more interest than your checking account. In exchange for this higher rate of interest, banks limit the number of transactions every month in a savings account.
- Advantages: the primary advantage is the higher rate of interest you earn compared to a checking account. Savings accounts also qualify for FDIC insurance, up to certain limits.
- Disadvantages: the main disadvantage with savings accounts is that banks limit the number of withdrawals you can make each month (general limit is 5 per month).
Money Market Deposit Accounts (MMDA): similar to a savings account, MMDA’s pay an interest rate on the funds deposited into the account and often will offer added flexibility compared to a savings account (check writing and deposit card privileges).
- Advantages: offer added flexibility compared to savings accounts. Also, interest rates offered on these accounts tend to be higher than checking and savings accounts.
- Disadvantages: there are limitations on the number of withdrawals each month (Regulation D limits you to 6 transfers per month). MMDA’s usually have higher minimum balance requirements than checking and savings accounts and may impose fees if your balance falls below certain thresholds.
Certificates of Deposit (CD’s): think of a CD as a timed savings account. A bank will agree to pay you a fixed rate of interest, and in exchange for this interest, you agree not to withdraw your money for a fixed amount of time. This period can be as short as 1 month to as long as 3 years (or even longer). If you keep your money in the CD for the specified time, you will receive the full amount of interest.
- Advantages: you have the potential to earn a higher rate of interest than checking, savings, and even money market deposit accounts. CD’s also qualify for FDIC insurance, up to certain limits. Another advantage is you can choose the amount of time you want to lock up your money for.
- Disadvantages: you must lock up your money for a specified amount of time or you could face penalties and forego any interest. CD’s tend to be the most “illiquid” of the options discussed here.
We cannot stress enough the importance of building and maintaining an emergency fund. The specific vehicle that is appropriate for you will not only depend on the interest rate you can earn but also your total financial situation. To learn more about how an emergency fund fits into your overall financial picture and the vehicle that is most appropriate for you, please contact us here.