Where to invest an emergency fund

by Scott Falls on May 2, 2011

Putting money into an emergency fund sounds simple. Actually finding the spare change to save a few bucks each month sound much more challenging. One of the most common questions I’m asked is, “Where do I invest my emergency funds?”

It’s not 100% cut and dry and you’ll have do a little bit of math (like 3rd grade level nothing too bad..) but I’ll illustrate a basic guideline I like to use when “stashing cash”, I mean… saving money in an emergency fund.

First things first, you have to determine how much you’ll need for a year’s worth of expenses. Here is a simple method I use to determine what you would need to cover your expenses for a year. Yes, I said a year, I believe in order to  has full financial peace (to coin a Dave Ramsey phrase) you should have one full year’s worth of expenses in reserve.

After determining what you need to save to fully fund an emergency fund (a year’s expenses – I’m going to use $40,000 in this example.), the next step will be a plan to save that money for maximize returns and eliminate risk.

Let me first start by explaining what an emergency fund is not. Notice I never used the word INVEST, when saving money for emergencies that last think your trying to do is make a lot of money. That doesn’t mean you shouldn’t get any return on your savings but this is not a vehicle where you’ll be investing in stocks or options or stock-based mutual funds.

This is money that you need to be able to rely on being there in the event of an emergency. The last thing we want to do is put any of it at risk. We are not trying to “make money” on our emergency fund savings. We are basically preserving principal and finding rates of returns that hopefully will allow us to keep up with inflation.

So let’s get back to the $40,000 we’ll be using in this example. Suppose you are working the Dave Ramsey Total Money Makeover, id you read my review you’ll know that I recommend saving 3 months expenses first (then go on to retirement, children’s education..etc).

Read My Dave Ramsey Review Here

The first 3 months of our emergency fund will be saved in a regular good old fashion savings account. Even if you get .25% interest.

This first 3 months ($10,000) needs to have 2 things:

  • Absolute Security (FDIC Insured)
  • Complete Liquidity (You need to be able to walk into the bank and withdraw your money immediately and penalty free

Don’t worry about:

  •  Rate of Return (you’re only focus should be liquidity and security)
  •  Locking in anything (we need liquidity)

The next focus will be on trying to gain a little return on the remaining $30,000. Basically we’re trying to keep up with or slightly beat inflation while keeping the investment secure.

For the next 3 months (months 3-6)  We’re going to lock in some savings. So using the same example the next $10,000 we’ll invest in CD’s. These are basically time deposits were we’re penalized if we withdraw month prior to term of the CD.

What I usually recommend is taking the maximum amount of money you can invest in a given month and invest it in a CD. I’ll assume we can save $1,000 per month towards this goal. For the next 10 months invest $1,000 per month in a 3 month CD (if the rate is much better on a 4 or 6 month CD you can use that but don’t go past six months with this $10,000)

As these CDs mature you will consistently roll them over (take the proceeds and invest in another CD) into a six month CD. So you will put 10 monthly contributions of $1,000 in 3 month CDs then starting on the 4th month you’ll have one matures you’ll invest in a six month CD for the next six months. So after you’re done with the 2nd $10,000 you should have a six month CD maturing every month.

Just continue rolling over the full balance of that month’s maturing CD into a new 6 month CD and you should see a nice little increase in your rate of return.

The last six months of your emergency fund should be no different. You can stick to the CD strategy but start looking at the best rates that you can get (up to a years duration). Sometimes banks have a weird higher rate on an 8 month or 14 month CD ( try to stay within a year but if you get a really incredible rate of return you can go as far as 16 months, but no longer than that)

The reason I’m recommending a slightly longer duration than a year is because after we establish our one year emergency fund, we’ll start investing for wealth. The beginning stages of our wealth building will overlap the emergency fund a little, so we can look for better returns.

If a catastrophe struck, it’s not like we can’t get the money if we needed it, we’d just have to forfeit some interest.

The goal with the CD strategy is to invest monthly into CD’s so that every month we have another CD maturing. Then we reinvest that money (including interest earned) into a new CD. Our goal with the emergency fund is to have insurance (FDIC) that our money will be there when we need, returns are secondary (should look for returns to keep up with inflation not create a ton of income, unless you can do that at zero risk)

What if a money market is paying a better rate than CD’s?

As long as it satisfies our emergency fund rules. 100% security, and 100% liquidity for the first three months and then have a portion of our money rolling (into maturity) each money for a little better returns.

If a money market at a bank or credit union is paying a greater rate of return than CD’s are currently paying then, by all means, invest your money there. If it’s FDIC insured (or NCUA for credit unions) and you don’t have any time restrictions, then that sounds like a home run. Just keep your eye on the rates in case they change.

What about investing in a government bond fund in my brokerage account?

While short term government bonds have traditionally been a good place to park cash earmarked for conservative investments, bond funds do not meet our 100% insured investment criteria. You see, as interest rates rise the bond our investment (our principal falls) and conversely as rates fall our principle rise.

The last thing we need to the market to tank, or your company decides to “right-size” your position right out the door thanks to some yutz consultant’s recommendation whose company will get paid twice as much as your salary for the input.

The last thing we need in a situation like this (an emergency) is for the principal of our emergency fund to be at risk. This is why you need to follow the two rules with your emergency fund and you’ll be ok.

  •     Absolute security (FDIC or NCUA Insured)
  •     Liquidity (Need to able to get to your money when you need it)

Follow these steps and you can sleep like a baby knowing that your in a position to weather just about any storm.

~Scott

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