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Buying Non-Laddered CDs With Your Emergency Fund

Written by Nickel - 14 Comments

A few years ago, we did something with our emergency fund that most financial experts will warn you against… We tied it up in long-term CDs. No, we didn’t build a CD ladder such that we’d have periodic access to a portion of our funds. Instead, we socked it all into five year CDs.

What were we thinking?

When it comes to CDs, the longer the term, the more you (usually) earn. Of course, the tradeoff here is that your money is tied up for a longer period of time. The good news is that you can typically break your CDs early, subject to an early withdrawal penalty. So… We rolled the dice.

We locked in our money at a higher yield knowing that we might have to forfeit a portion of the interest if we had to tap into it early. The primary reason that we did this is that we ran across a screaming hot deal on five year CDs back in early 2004.

At the time, interest rates even for the best online savings accounts were near an all-time low due to repeated rate cuts by the Fed. While we could’ve laddered our CDs, shorter term yields were paltry compared to what we were able to get by committing to a longer term. In fact, even after factoring in the early withdrawal penalty, we’d come out well ahead by locking our money away and forfeiting a portion of our interest on the off chance that we’d need to access the money.

In other words, it was a no-brainer.

Minimizing our downside risk

The only real risk that we faced in structuring things this way was that we might have to break into the money and pay that early withdrawal penalty. In our case, however, the penalty was just three months interest and, as noted above, we’d still come out ahead as long as we didn’t need to tap into that money within the first six months or so.

In order to further minimize our risk, we decided to split our money up and buy five identical CDs in parallel. By doing this, we minimized the penalty that we’d face if we only needed to access a portion of our emergency fund. In other words, if we only needed to access 20/40/60/80% of the money, we could just break 1/2/3/4 CDs and let the balance keep chugging along.

In the end, we were fortunate in that we never needed to touch that money. It comes up for renewal in January 2009, at which point we’ll consider our options. However, we’re in a much more stable position now, and have other resources on which we can draw.

Things to watch out for

If you’re considering this approach, here are a few things to keep in mind:

  • Make sure you can get your hands on the money. An emergency fund is only useful if it’s accessible for use in case of an emergency. If you can’t get same-day access to the money, then you’d be well advised to keep some portion of your emergency cash on hand in a local bank.
  • Double check the early withdrawal penalty. The lower the better. Forfeiting three months of interest is probably the best you can hope for. Many banks charge substantially more.
  • Consider your situation. The more stable your situation, the less likely it is that you’ll have to break into those CDs. Also, the larger your emergency fund, the more (in terms of absolute dollars) you will benefit from seeking out a higher rate of return.
  • Consider your alternatives. If the spread between prevailing interest rates and what you can get with a longer-term CD isn’t sufficiently large, this might not be worth the trouble.

The bottom line

While this approach might not be for everyone, you can squeeze a good bit more performance out of your money if you’re willing to think outside the box. Sure, it takes a bit of additional work, but there’s no real risk as long as you know what you’re getting into. If you’d prefer a more traditional approach, you might consider building a monthly ladder for your emergency fund instead.

Published on November 3rd, 2008 - 14 Comments
Filed under: Banking

About the author: is the founder and editor-in-chief of this site. He's a thirty-something family man who has been writing about personal finance since 2005, and guess what? He's on Twitter!

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14 Responses to “Buying Non-Laddered CDs With Your Emergency Fund”

  1. 1
    gm Says:

    I agree with the premise of the post.Also, these days when a 6 moth CD pays more than a money market account, it is often better to create a CD. For six month CDs the early withdrawal penalty is only 1 month of interest.

  2. 2
    Ken Says:

    Early withdrawal penalties can vary substantially. For terms over one year, a 6-month interest penatly is the most common. But sometimes it can be the interest of half the term. If it’s a 5-year CD, that’s 30 months of interest. E*TRADE is an example of a bank that has this huge early withdrawal penalty.

  3. 3
    frugalchick Says:

    Wow! This is definitely thinking outside the box. I would never consider this approach in the past but your post raised a lot of good points. I’ll be keeping an eye on long term CD rates from now on.

  4. 4
    Stacey Says:

    Some banks now let you cash in part of the CD early if you need to, and only penalize you for the portion you’ve cashed in. If you have a $5,000 CD and need $1,000, you pay the 3 month penalty on the $1,000.

    We belong to a small, local bank in Pennsylvania. I’m not sure if larger banks do this yet, but it was a real surprise for us when we opened our latest CD. No more laddering for us!

  5. 5
    nickel Says:

    Stacey, that’s a great feature. Of course, a ladder (once it’s completely built) would still be superior, as you wouldn’t pay a penalty on any of the money — just use the funds from whichever one has come due.

  6. 6
    Christopher Desmond Says:

    I needed to bust up 5 CD’s at 3 banks back in 2006 for a hot investment that’s since paid off for me. When I called up penfed.org to check on the penalty, this very nice gal told me about a “CD Loan.” Worked like this: Say you have a CD that’s now, with accumulated interest, worth $100,000 and it’s yielding 5%. Assume you want that $100,000 now but there’s 2 years left on the CD. The bank will give you the $100,000 now and charge you only 5.25% (hence, net .25% interest cost to you) on the loan, which terminates in 2 years when the CD matures and the bank pays itself back out of the CD’s maturation proceeds. I had my CPA run the numbers and this way wound up cheaper than just breaking the CD and paying early liquidation penalties. Went smooth with penfed and the 2 banks. Plus one bank reported the successful loan on my credit record, thus assisting my credit score (I hadn’t borrowed any money since 1987 and have always paid off my credit card balances promptly to avoid ever paying any interest on them). Anyway, I hadn’t heard of a “CD Loan” until the penfed.org gal turned me onto it. The 2 banks were almost as reasonable with the rate, too (.25% and .32%).

  7. 7
    Nick Says:

    That’s a pretty nice deal Christopher. Personally I think that CDs are a great idea as long as you have some emergency money stocked away, in a high yield savings or something similar. Then if even that’s not enough, worst case is that you cash out some of your CDs, hopefully without too much penalty.

  8. 8
    Dave Says:

    Still think high dividend yields are better – especially now that they get preferential tax treatment.

  9. 9
    Taxrascal Says:

    One trick you can try next time: if you’re breaking up $5,000 into five chunks, don’t make them equal: divide them so each chunk is half as big as the next. Since you’re dividing five times, that means your first chunk will be about $160, then $320, then $640, then $1280, then $2560.

    Why? Because this maximizes the number of different amounts you can withdraw. If you divide your $5000 into equal $1000-dollar chunks, you can withdraw in $1000 increments. If you split them up this way, you can withdraw any multiple of $160.

    This, of course, assumes you’re only withdrawing once.

  10. 10
    Tim Says:

    we have half our e-fund in long term cd’s too, but that is because there is like 99.9999999% chance of losing job and because we have half in tax free mmf.

  11. 11
    Dexter Says:

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  12. 12
    San Antonio Attorneys Says:

    Quite often, though, I had the itch to find something better to do with the money. I eyed putting some of it in CDs (certificate of deposit, which basically means you give a certain amount of cash to a bank for a specified period of time â?? it earns a higher interest rate than a savings account, but youâ??re penalized most of that return if you cash it in early), but I didnâ??t want to lock up a huge amount of it for a long period of time.

  13. 13
    Kelly Says:

    If you are going to use the CD ladder for emergency funds, the main purpose for those funds is having them available when an emergency happens. If you can gain some interest on the funds, that’s a bonus.

  14. 14
    Jenna Says:

    CDs dont pay enough more than savings to justify tying up the money. However, the rates on savings have steadily gone down over the last few years and I would have been better off to have locked into a CD back when rates were higher.

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