My husband and I have been debating what to do with our emergency fund. Should we keep it all liquid in an online savings account currently earning about 1.22% interest or put some it in a CD ladder? There are pros and cons of both options, so really it comes down the size of your fund and how liquid you need it to be.

Fully Liquid Emergency Fund
Right now our money is in a savings account earning a piddling amount of money in interest. Because the Fed rate is 0%, savings interest rates are low. For a while, banks were offering high teaser rates, but those don’t last long.

However, we chose to keep the fund fully liquid for the time being so that we would have full access to it while my husband is on disability. We haven’t had to tap it, but it’s there if we need it.

So here are the pros of the liquid emergency fund:
Always available. If your roof caves in during a storm, the money is ready to go. No need to wait for the funds or get financing in the interim.

Easy to access. We just transfer it from our online savings account to our checking account. It takes about three days for the interbank transfer.

No fees for withdrawing. We can take our money out anytime we want and we can add money to it whenever we want.

There are also cons to the liquid emergency fund:
Low interest rate. If you want to make money off your money, then a savings account isn’t a lucrative way to do that.

Temptation to spend it on non-emergencies. If we had less self-control, we might use that money for other purchases because it’s so easy to access.

CD Ladder Emergency Fund
You should always keep some money fully liquid. I’d keep at least one mortgage payment in cash – you never know when the bank will screw up (or when you and your husband will accidentally overpay the mortgage.) However, once the minimum is covered, you could move some of the emergency fund into CD ladders.

Pros of the CD ladder emergency fund:
Higher interest rate. Rather than 1%, CDs typically earn 4% or more. Not a huge amount, but a lot. When you ladder it into 1, 2, 3, 4, and 5-year CDs, interest rates climb with each year.

No temptation to spend it. If you want to break open a CD early, you usually have to pay a penalty. You can get no-penalty CDs, but the interest rate is lower.

Cons of the CD ladder emergency fund:
Difficult to access. If you need the money to fix your caved-in roof or overhaul the engine on your car, you either have to wait until the CD matures, and then wait for them to send you the money after you request it, or you have to break it open early and pay the penalty. In the meantime, you might have to get financing to cover the repairs, and that could cost more than the interest from the CD.

For now, we’ll stick with our liquid emergency fund, but we may start CD laddering as it grows. I’m thinking the right ratio would be 50% cash, 50% CD ladders. Then we would have enough to cover the initial emergency cost, and would be earning more interest on the rest in case a serious emergency (like a massive earthquake) develops.

Comments

2 Responses to “Pros and Cons of Liquid Emergency Funds vs. CD Ladders”

  1. Caro on April 19th, 2010 8:17 am

    For us it depends on the CD terms and rates.

    Right now interest rates on CDs are not all that much better than regular savings. So we are letting our CDs fall out of the ladder at the moment. Though I have been thinking about the really long term Ally CDs as they only have a 60 day interest penalty.

    Which brings us to my second factor, the actual penalty. For a long time I had no idea that I had it so lucky with my credit union. The fee for them is 1 month of interest for their shorter term CDs and 2 months for longer term. This means that what I risk is only as much as I would have earned for those months otherwise.

    I have had to take a few CDs out early and it was a simple matter of calling them and having them transfer the money back into my checking….at which point it was available immediately.

  2. Aryn on April 19th, 2010 11:57 am

    That’s an excellent point. Some CDs charge six month’s interest as a penalty, so the damage is much steeper, especially for a CD at 4-5% interest (I remember when you could get 6-7%.) If you’re only earning 1-3%, then it may not be worth it to tie up your money for a few extra bucks a year.

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