In personal finance, one of the most important foundations is an emergency fund. Some people use credit cards in event of an emergency, but having cash is the only way to really ride out some of the storms life can throw your direction.
The problem with emergency funds is they need to be available at a moments notice for things like car repairs or job loss. Because of this, it is not recommended to tie it up into long-term investments that are illiquid. For many, that means parking the money in a savings account earning next to nothing, and that does not sit well with those looking to maximize the earning power of every dollar they have.
Most finance experts recommend having at least six months worth of expenses in the form of an emergency fund. The number one life changing emergency that people run into is job loss, which requires you to cover your expenses for an extended period of time. The good thing about a job loss compared to other more rare events is that the need for money is drawn out over time.
The CD Ladder
A certificate of deposit (CD) pays better interest than a standard savings account in return for not touching the money for a predetermined period. A CD Ladder is a series of CDs bought and sold at regular intervals that creates a “revolving door” of funds always becoming available.
CD Ladder Emergency Fund
Since buying one certificate of deposit to put your emergency fund in would not be wise because you would either have to break the CD and pay fees to access your money, or you could be tempted to use credit in the event of an emergency to prevent paying fees. By using a ladder approach, you can guarantee access to funds at all times.
Here is how you setup a CD ladder:
- Divide your emergency fund into equal parts based on how many months you have saved and add one. For this example we will use a six-month emergency fund, so you would divide it into seven equal parts.
- Buy a six-month CD using 1/7th of the emergency fund.
- Every month around the same day, purchase another six month CD with 1/7th of the emergency fund.
- Once six CDs have been purchased, begin using the matured CDs to buy new ones every month.
There are a few keys to this approach. First, by staggering your CDs every month you will have access to cash continuously. Since the majority of emergencies are job loss related, you rarely need all your emergency funds at the same time. Every month when a CD matures, you can take the money and use it for your expenses until you get a new job.
Second, if you did need a sizeable amount all at once, by having your money broken into six different CDs you can break only the ones you would need. Since these would all be smaller CD amounts, the penalty for breaking them would be less.
Third, by breaking your emergency fund into seven parts instead of six, you would always have some cash available immediately until the next CD matured.
No matter which route you choose to store your emergency fund, remember it is there to add piece of mind. The main goal of this cash is not to provide large interest payments, so chasing dangerous investments should be avoided at all costs. Its better to earn less but have your money protected, than to go after higher returns and increase your risk dramatically.
Eric Stauffer is a personal finance and insurance expert. You can find his GEICO reviews and nationwide review, as well as information on how to shop for insurance products and get the best deals on his blog.