Paul Vs The Market

Have you heard the doomsday stories about how unprepared Americans are for unexpected expenses? The numbers vary: 40% can’t cover a $400 expense, most would go into debt over a $500 expense, only 39% can cover a $1,000 emergency. They all tell a similar story, though: many Americans don’t have any significant source of savings that they can draw upon.

The solution that many people recommend is an emergency fund. An emergency fund is just what it sounds like: a stash of money to deal with unexpected emergencies. Advice varies, but most people seem to suggest that a good emergency fund should at least cover 3 months of expenses.

Because it’s supposed to deal with unexpected emergencies, the money should be pretty liquid (ie, easily accessible). Equity in a rental property would make a terrible source of emergency funds because it would likely take months to be able to get access to that money. At the same time, a good emergency fund should be pretty safe in terms of not being in risky investments. The last thing you want is to have your 3 months of expenses cut down to 2 months of expenses right when you need it because there was a market crash at the same time as you need your appendix removed.

Because it’s pegged to spending, an emergency fund that covers three months of expenses is likely going to be a significant amount of money (relatively speaking) for most people. For my family, with a mortgage in the expensive Northern Virginia housing market and two young kids, three months of expenses is easily over $10k. It was killing me to keep so much money in a checking account earning no interest.

CDs

Thankfully, one of the positive side effects of interest rates rising is that some of the safer savings vehicles are starting to have respectable returns again. Once I started seeing rates for CDs had hit 2%, I decided it finally made sense to take the plunge.

What is a CD? It stands for “Certificate of Deposit”. I think of it as similar to a savings account with slightly more restrictions. However, in return for those restrictions, CDs provide a slightly higher interest rate. CDs have a term (usually from 1-5 years) which is the amount of time you agree to give the money to the bank without withdrawing it. In return, you get a guaranteed return that usually beats what you can get in a savings account. Since CDs are also FDIC insured, it’s close to a risk-free return. In the case of an emergency, the money can be withdrawn early before the end of the term for a penalty.

“But I thought emergency funds were supposed to be liquid? Paying a penalty to withdraw early doesn’t sound very liquid to me.” Yes, random interjecting voice, paying a penalty to withdraw funds early from a CD isn’t ideal, but the penalty is typically pretty minor (a few months of interest). Still, in order to avoid potentially having all of their money tied up for a year or more and to take advantage of environments where interest rates are expected to go up (like today’s environment), many people choose to ladder their CDs.

CD Laddering

What is CD laddering? Let’s say you have $8k you want to put into CDs but would rather not have the entire amount tied up for a long time. You could put all $8k into a 3 month CD, but the interest rate on that CD is lower than the interest rate on a 1 year CD. Is there a way to get the best of both worlds?

Kinda. Think about this compromise:

Name	Amount	Term
CD #1	$2,000	3 months
CD #2	$2,000	6 months
CD #3	$2,000	9 months
CD #4	$2,000	1 year

This invests all $8k into CDs, but if an emergency happens you are never more than 3 months away from a CD maturing and having penalty-free access to the money. You also get some benefit from the higher interest rates that longer term CDs provide. Even better? If CD #1 matures and you don’t need access to the money, you can now re-invest that into a new 1 year CD (with possibly an even higher interest rate than the one from CD #4 if interest rates have gone up in the past 3 months) to keep the ladder going. Here is what your new ladder would look like then:

Name	Amount	Term
CD #2	$2,000 + some interest	6 months (3 remaining)
CD #3	$2,000 + some interest	9 months (6 remaining)
CD #4	$2,000 + some interest	1 year (9 months remaining)
CD #5 (formerly CD #1)	$2,000 + interest from CD #1	1 year

The cycle can then start over when CD #2 matures. There are a lot of things that can be tweaked with this formula for an individual’s specific circumstances as well. Don’t think you’ll potentially need money every 3 months? You could ladder CDs with 1, 2, 3, and 5 year terms instead. Maybe you want the safety of a CD maturing every month? Split the money into twelfths instead. There’s a lot of flexibility with CD laddering.

Up until recently, the best rates that I have found for CDs so far have been with Synchrony Bank. Over the past year or so I’ve started slowly transitioning my emergency fund money from my checking account to CDs with Synchrony. Every few months they’ve been bumping up the rates on their CDs and that’s when I open a new one with a portion of my remaining emergency fund. Right now I have 6 CDs open averaging around 2.5% APR.

Robin Hood to the rescue?

The phrase “until recently” may have caught your attention in the paragraph above. That’s because just this morning I saw a headline that Robin Hood is planning on offering checking and savings accounts that will pay a 3% interest rate. While that’s still significantly less than the average return of the stock market, it’s ridiculously better than most comparable alternatives right now. My checking account is currently with Bank of America and as of the day I am writing this, the absolute highest interest rate their savings accounts pay is 0.06%, and even that is reserved for individuals with a large amount of money with the bank. Yes, that’s right, Robin Hood is proposing to offer an interest rate that is 50 times greater. Beyond that, the 3% rate tops even the rates that I mentioned above that I was getting on CDs, and it doesn’t requiring tying up your money for a specific term.

I had been playing around with Robin Hood a little bit for a few months since I had heard good things about it, so I figured I would put my name on the list to get access. The service is supposed to launch in “early 2019”. Assuming it’s all that it’s cracked up to be (or event just most of what it’s cracked up to be), then I might consider moving my emergency fund out of CDs and into this Robin Hood savings account. If you’re interested in putting your name on the list, you can try out my referral link here. If I understand their referral program, then I think we both get a free share of stock in a random company. That could be icing on the 3% checking account cake.

So that’s how I’m handling my emergency fund right now, and some insight into how I might handle it in the future. What about you? Where do you put your emergency fund? How many months of expenses do you try to have saved up? Would you be interested in trying Robin Hood’s new offering? Do you have an even better place to put an emergency fund? Let me know in the comments. Thanks!