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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.