What does every personal finance expert say is the first step to financial freedom? Starting an emergency fund.
It should be pretty obvious why this is so important: emergencies are a fact of life. If your car broke down or you had to fly out of town for a funeral, how would you pay for that unexpected expense? An emergency fund takes some of the stress out of these stressful situations, since you know where the money will be coming from.
Where Should You Keep Your Emergency Fund?
Unfortunately, even though the need for an emergency fund is obvious, where to stash it is definitely less so. If you’re hoping for a more secure spot for your emergency fund than under your mattress, here are your options, and why you might want to choose each one:
1. With your current bank. For those just starting an emergency fund, opening another account with your current brick and mortar bank can be a great option. You will be able to link your current checking or savings account with your emergency fund, which will make it very easy to set up automatic transfers into the account. Using your current bank also means that you can make deposits in person or at an ATM.
The downside to this, however, is how easy it is to access your money from this account. Just as you can deposit money into your emergency fund from the ATM and with a teller, you can also withdraw money just as easily. In addition, you will earn next to no interest with this option.
However, if you have the discipline to leave your money alone, this is a good place to safely build your emergency fund from the ground up.
2. Online savings accounts. Though these accounts are not as convenient as a local brick and mortar bank, they do offer much better interest rates. (In 2012, interest rates at online banking powerhouses like ING Direct and Ally have not topped 1%, but just a few years ago you could find monthly rates in the 2%-4% range.) You can deposit money in these savings accounts through linked traditional bank accounts, as well as by mailing in deposits.
The lack of convenient access to your money can often be a boon. It generally takes about two to three business days for money to fully transfer from an online savings account, which is plenty of time in the face of a true emergency (I often will pay via credit card, for example, and use the emergency fund money to pay off that bill), but is far too much time when spending temptations strike.
3. Certificate of Deposit. A certificate of deposit, or CD, is an insured and interest-bearing account that has a fixed term, during which time it is not in your best interest to withdraw your money. Since you (theoretically) keep your money in the CD for the entire term, banks will offer you better interest rates than you can receive from any savings account. If you withdraw your funds early, you will have to forfeit some amount of interest—generally about two to six months’ worth.
Stowing your entire emergency fund in a CD is not a great idea, since it is not particularly liquid. However, if you also have money set aside in a more accessible account, putting away a portion of your emergency fund into a CD is a good way to make sure you still have funds set aside for “life happens” moments, while still earning some interest on that money.
4. I-Bonds. These U.S. Savings bonds are inflation indexed, which means you start with a particular rate of return when you buy them, and those rates are readjusted every six months to reflect the rate of inflation. In short, these are a good place to earn real interest on your money—and you defer paying taxes on your earnings until you cash our your bonds. However, you cannot withdraw your funds from I-Bonds for a year after you have purchased them.
Again, while I-Bonds can do more with your money, you will be up a creek if you put all of your emergency fund into them. In addition, there is a $10,000 purchase limit per person per year. Wait to buy an I-Bond until you have a good emergency fund established and can afford to put a portion of it out of reach.
The Bottom Line
Starting an emergency fund is the most important part of this process. Once you get in the habit of putting money aside, then you can decide where your money will work best for you.