Building an emergency fund(EF) is one of the first steps you can take in order to get your financial life headed on the right path. Whether you’re just starting to pay your own way, or 5 years into your career, financial emergencies can happen at any time. Medical expenses, getting laid off and even minor car repairs can seriously damage your finances if not adequately prepared. An emergency fund will help you absorb these one-time costs without going into debt.
With that being said, each situation is unique and requires a customized approach. The first step you should take is to save $1,000; this should cover any type of minor emergency. Now it’s time to pay off any debt you may have.
Paying off Debt
It’s pretty easy to figure out which type of debt is having the largest effect on your wallet. Any type of high interest credit card or auto loan debt should be paid off immediately.(A line of credit should not be used as an emergency fund!) It’s very difficult to make headway in paying off debt and saving for an emergency fund at the same time. So once you have your debt under control, it’s back to building that emergency fund. I try to keep about 6 months worth of expenses in my EF. Most of you in the early stages of your career should feel comfortable with 3-6 months.
What to do with the money?
Since we need the money to be liquid and accessible, there are only a few safe investment options for our EF. With savings rates at an all time low, I recommend taking advantage of a strategy known as a CD ladder. There are a couple different methods, but most have the same basic principals. A CD ladder staggers your certificates in a sequence of 3 months, 6 months, 9 months, 12 months. As one CD matures, it is rolled into a new ladder.
An example:
Emergency Fund: $10,000
Every 3 months, you would purchase a 1 year CD in the amount of $2,500.
Your purchase dates would be Jan. 1, April 1, July 1 and October 1.
When our first CD matures, we roll it into another 1 year certificate and continue building the ladder. We now gain the higher interest rate assigned to CD’s while keeping our money liquid. Most emergencies will not require the entire emergency fund, so we will only need to break one rung of the ladder to access our money. The penalties for terminating a CD are different for every bank, but generally never exceed one to three month’s accrued interest. The CD’s will return interest to the principal and renew every year in order to maximize your money.
Some Current CD Rates(as of 2/2/2012)
Ally Bank 1 year CD: 0.99%
ING Direct 1 year CD: 0.50%
Bank of America 1 year CD: 0.45%
Make Sense? How much do you have saved in your EF? Do you think it’s more important to have a larger EF before paying off debt? Let me know what you think..
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Any particular reason you recommend a CD ladder instead of an online savings account or something of that sort? Most of the online accounts are in the 0.75% – 1% range now and offer more liquidity than CDs.
Kelly, for a beginning investor, I think a competitive online savings account should be just fine. However, for a more intermediate to advanced investor, I recommend a CD ladder for the extra APR. Although .1 or .2% may not seem like much, little amounts like this do add up when spread across all your investment/retirement accounts(similar to expense ratios in managed funds). At any banking institution, online or brick and mortar, the CD rates will always be higher(however slight) than any type of savings account.
For example, I bank with Ally, and my 1 year CD has a termination fee of only 60 days interest and the money is accessible within 1-2 business days.
Thanks for the comment!
check out ING
Hey PFPro, I use Ally as well but instead of laddering I put all my money in 5 year CDs since they pay the highest rate (1.74% right now). The best thing about Ally CDs are that they only charge you a 2 month penalty if you break out of your CD. If you do the math, you’ll end up with more money in a 5yr CD if you broke out of it in 5 months then you would in a 1yr CD (after 5 months without penalty).
I split my emergency fund into 4 separate CDs. I hope to never have to break out of them, but if I do need extra cash, I might break out of 1 of my CDs (possibly more). Knowing that I just need to hold the cash for 5 months to automatically end up better than a 1 yr CD or savings account makes it worth it for me. Hope this helps some other people!
Hey Mark, thanks for the comment 🙂 That is a great point you bring up. I provided this example for simplicity to explain how the ladder works.
But personally, I use 4 year raise your rate CD’s for the reasons you mentioned above.