Articles about emergency funds may have put you to sleep as recently as a year ago. You would have been lucky to find a high-yield savings account paying out 1%-2% at that time.
However, with interest rates soaring, cash investments can post sizable returns, driving some of the highest interest payouts in decades. This is the perfect time to make a case for why building an emergency fund is essential in high- and low-interest rate environments.
Where to keep your emergency cash
An emergency fund is a cash cushion of roughly three to six months of living expenses. If your job is unstable, a family member has significant health issues, or you are solely responsible for all your bills, you should aim for even higher amounts. It is not unheard of to see emergency funds covering a year’s expenses. Having this extra cash buffer will protect the wealth you’ve built so that no situation can jeopardize this and cause your financial world to crumble.
However, simply keeping your cash in a checking account will not do much for you, and a regular savings account is not much better. According to the Federal Deposit Insurance Corp., the national average annual yield (APY) for savings accounts was a paltry 0.39% as of April 2023.
Aim to put your money in a high-yield savings account that offers FDIC insurance up to the $250,000 limit. Some online savings accounts are paying rates as high as 4.75% APY. Banks such as Ally, CIT Bank and SoFi offer some of the best rates. American Express High Yield Savings and Barclays Online Savings Account are highly competitive. Be sure to check the account’s minimum deposit and ongoing balance required and if there are any ongoing account maintenance or other fees. These accounts may also have a limit on the number of times that you can move or withdraw money each month. However, if this is your emergency fund, you should not be touching it often.
A certificate of deposit is another option. CDs can be a good choice for getting even higher rates than online savings accounts if you are willing to invest in a long-term CD. CDs are savings vehicles that “lock up” your money for a fixed amount of time — from three months to five years. During this period, your cash will earn a fixed interest rate, and the longer the maturity chosen, the higher the APY. For example, six-month CDs currently offer up to 5.0%, and two-year CDs are even more appealing, paying around 5.20%.
While the prospect of making more money is attractive, there are downsides to owning CDs. CDs do not let you transfer money in and out. If you tap your CD before it matures, you will be charged a penalty in the form of reduced interest paid. The penalty can range from as little as forfeiting three months of interest to a much more painful loss of a year’s interest. Therefore, CDs are better for people who do not need to access this money and have cash built up in a high-yield savings account that they can easily use for emergencies.
Saving is key for short-term goals, too
Savings for goals with a time horizon of 1-3 years should not be invested in the stock market. This is true for house acquisitions, car purchases and more. But, of course, the same rules for high-interest savings accounts and CDs still apply.
Client case: Why you need to save as well as invest
A potential client — let’s call her Jane — contacted me last week about hiring Francis Financial as her wealth manager and explained that she was very concerned about the losses she sustained in her portfolio in 2022. She explained that her portfolio dropped in value so much that she was unsure how she would ever recover, and she just lost her job at a major tech company.
After speaking to Jane for a half-hour, I learned she is a retirement savings role model and had been maxing out her 401(k) yearly. She also worked for another tech company years ago and was able to save into their retirement plan and roll this into an IRA. Between her 401(k) and IRA, Jane has over $455,000 in her retirement nest egg.
Over the years, Jane saved a portion of her bonus and invested this money in a taxable brokerage account. Her portfolio was invested extremely aggressively as she wanted to supercharge the return so that she could purchase a home sooner. Unfortunately, Jane had terrible timing. The taxable brokerage account that was earmarked to buy her dream home was worth over $255,000 at the end of 2021, and its value is now only $185,000.
Understandably, Jane is upset, but her situation could have been avoided, as she failed to plan for the unexpected. Jane should have put her down-payment savings in a high-interest account or CD. Now she is forced to sell her portfolio after her stocks have taken a beating. Stocks almost always outperform cash, but not in a down market.
Withdrawing money from her retirement plans is also a “no-go” option. Because Jane is not yet age 59½, she would have to pay taxes and penalties on any money she takes out.
Even if Jane puts off purchasing a home, she will still have to tap her taxable portfolio because she does not have an emergency fund. But unfortunately, she was so focused on saving money for retirement and investing big that she forgot to plan for today.
Hacks to build a savings habit
While it may seem daunting, setting a goal and planning will allow you to save in a way that works for your cash flow.
Diversity Woman, a publication that empowers women of all backgrounds, shares that even saving 5% to 10% of your paycheck can result in a well-cushioned emergency fund and put you well on your way to building your financial safety net in no time.
The easiest way to reach this goal is to automatically have a portion of your paycheck directed toward your emergency or short-term savings fund. Your emergency fund and short-term savings should be directed toward something other than your everyday checking or savings account. Instead, have a separate place for these savings.
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Studies have shown that naming the account “Emergency Fund” or after the name of your goal, such as “Home Fund,” also helps motivate savers to supercharge the amount and frequency of their deposits. Better yet — get specific. For example, call your savings account your “2027 Hamptons Dream Home Fund.” Fewer people will tap money in a fund named this way for non-goal-related reasons, allowing these monies to grow over time.
By naming your bank account to match your goal triggers, you can better visualize achieving it, helping you stick with your savings plan.
Map out your goals and calculate how much you must put aside each month to achieve them. For most savers, your goals are more achievable than initially thought.
Be sure to consult a financial advisor if you know that advice and accountability are going to help you. This is especially true if you have several goals that you are trying to coordinate together. A certified financial planner can help you map out an action plan to reach each of these in the time frame you have set for yourself.
— By Stacy Francis, a certified financial planner and the president and CEO of Francis Financial in New York City. She is also a member of the CNBC Financial Advisor Council.
