Emergency funds are an important part of a strong financial plan. But if you leave too much of your money in a low-yield checking or savings account, you’re missing out on great potential interest and investment returns.
If you want to keep more money on hand than is recommended to cover emergencies, the solution may be to allocate money in categories based on what you need now, what you will need soon and what you will need later. Diversifying periods for each bucket can add layers of financial protection while generating high returns on your passive capital.
Why one emergency fund may need three jobs
Savings isn’t just for paying your monthly expenses. An emergency fund can cover surprises such as medical bills, home repairs or job loss. Financial advisors often recommend having enough cash readily available to cover three to six months of these expenses. You may also want to keep money accessible for short-term goals.
Having enough cash to cover immediate expenses and any surprises will go a long way in securing your financial future, but you also need quick access to your money. If it takes more than a week to tap into your emergency savings account, you may have to get a loan or sell stocks at a loss, which defeats the purpose of having an emergency fund.
While a checking account allows you to access money without worrying about large withdrawals and potential fees, you also get a lower interest rate with these accounts. But certificates of deposit (CDs), which offer higher yields, come with early withdrawal penalties if you withdraw your money before a certain length of time. A high-yield savings account (HYSA) is a great way to save money for emergencies, as it produces a higher yield than you’ll find in checking and savings accounts, and it’s more liquid.
‘Available now’ and ‘Available soon’ buckets
You may also want to keep your money in cash and other forms of money if you are saving for short-term goals, such as a vacation or a new car. That’s why dividing your wallet into buckets can make sense.
The “current” bucket can include money in your checking account that you use for day-to-day expenses and an emergency fund in HYSA that can cover three to six months of expenses in case the unexpected happens. “Soon” money is money that you will want to receive in the short term, such as six months to a year. You can keep this in a HYSA, CD (as long as it matures before you need the cash) or a similar account. You should look for a Federal Deposit Insurance Corporation (FDIC) or National Credit Union Administration (NCUA) insured savings account with no monthly fees and no minimum balance requirements. Fast transfer, easy internet access and no teaser-rate traps are also good advantages.
A bucket of ‘lots of money, but still safe’
This last bucket contains money that you won’t need for one to three years, and that you don’t want to invest in the stock market and risk selling at a low price.
Money in this category can go into short-term CDs and Treasury bills. These financial products allow you to protect the interest rate until the account matures. You can choose CDs and T-bills based on their maturity dates and create a CD ladder to make different parts of these funds available at different times. Most CDs have early withdrawal penalties, and penalty-free CDs have lower APYs.
CDs and T-bills have fixed rates, while HYSAs have variable rates that can change if the Federal Reserve decides to lower interest rates. Not everyone needs to invest in CDs and T-bills. For most people, HYSA is enough.
The exact amount of money you can keep in each bucket will depend on your specific situation. And remember, keeping too much money aside can mean missing out on high returns and not reaching your financial goals.
