Why you should use 5 year CD’s for your emergency fund

We have advised not to reach for yield by doing things like investing in P2P lending or beyond your risk profile.  This is especially true for one’s emergency fund, where it should be desired to have the money liquid with no risk of loosing principal.  These two characteristics of an emergency fund leave us with a few, unexciting options.  Unfortunately, today’s options don’t provide much inflation protection.

We don’t recommend bonds for an emergency fund.  Treasury Bonds may preserve principal, but are far from liquid.  Bond funds can be liquid, but they can’t guarantee your principal.

There are money market funds.  MMF’s provide excellent liquidity.  Vanguard’s Prime Money Market fund (VMMXX) has returned an exciting 0.04% the last year.  Like. Whoa.  Not to mention, a MMF is not FDIC insured.

Online savings accounts are another sexy option for emergency funds.  These accounts are FDIC insured up to the amount allowable by the gubmint (currently $250k).  They also offer a little better interest rate than a MMF.  We have a crush on Ally Bank.  We have also used ING and HSBC.  It should be noted, we don’t do the affiliate thing, so we don’t profit in any shape, form or fashion if you decide any of these banks are the perfect match for you (and ING shouldn’t be it*).  Ally’s online savings account has no fees, no minimums and a whopping 0.84% APY.  While that APY isn’t anything that will make you millions or even keep up with inflation, it is magnitudes better than the Money Market option cited above.  So, that’s a start.

The other option which provides your money liquidity and security is CD’s.  Certificate of Deposits can be liquid.  Typically, when you take out a CD, you promise to leave the money with the bank for some term and you lock in an interest rate.  Our crush offers 3 month, 6 month, 9 month, 11 month, 12 month, 18 month, 2 year, 3 year, 4 year and 5 year CD’s.  So which one would you choose?   Well, they also complicate the matter by offering some perks.  Some CD’s come with no penalty (11 month CD), meaning you can get a little higher yield and you have no penalty for breaking the term of the CD.  Others have a “Raise Your Rate” feature (2 & 4 year CD’s) where you have a one time opportunity to ask for a higher interest rate in the future.  It’s an interesting product to say the least.  But, we don’t recommend any of these CD’s.

The longer the term of a CD, the higher the return.  The implication is, you have your money tied up longer and you should be compensated for the longer term.  Well, what happens if you need the money?  There is a penalty for redeeming the CD early, and that penalty can range from forfeiting all interest earned or the last year’s, or the last 6 month’s or, in the case of Ally CD’s, the last 2 months’ interest.  Or anywhere in between.  But, forfeiting the last 2 month’s interest is an excellent deal!  This is why we recommend the longest term possible with banks like Ally.  Well, depending on the extra yield.  Here is how you calculate the time it would take you to “break even” (if you take a longer term-and higher interest rate-and redeem early, when do you come out ahead over a lower interest rate?) under Ally’s terms:This equation assumes compounding daily and gives the “break even” point in months (assumes 30 days/month).  Also, it is only for CD’s where the penalty is the last 60 day’s interest.  Please note, that you must use APR (annual percentage rate) and not APY (annual percentage yield).  Most banks will quote interest rates in terms of APY.  Please see this excellent article on the difference.  And since we are in the equation making mode, here is the equation to calculate APY –> APR if the interest is compounded daily:

How does this work?  Well, Ally is offering 1.74% APY (~1.72% APR) for a 5 year CD.  You are nervous about taking out such a long term, how does it compare to the “high” yield savings account Ally offers (0.84% APY/0.835% APR)?  Using the equation above, you find that t=4 months.  So, if you hold the 5 year CD for 4 months, even with the penalty, it is the same as having the money in the “high” yield savings account for 4 months.  Anything after 4 months is extra yield you will reap!

But, there is more!  To have your accounts insured by the FDIC, you can have 1 account worth up to $250,000, or you can 250,000 accounts of $1 each.  Both of these scenarios (or any mix in between) are insured the same under current rules.  Why is this important?  Say you have a $10,000 emergency fund and you decide to actually follow our advice to open up 5 year CD’s.  And, in two months, you need $1500.  Well, if you opened up just one $10,000 account, you will pay the penalty on the entire amount.  If you opened up 10, $1000 accounts, you would only pay the penalty on $2000.  And you are still covered by the FDIC!

Please, please, please read the fine print before taking out any CD’s.  We obviously would recommend Ally because their 60 day interest penalty is the best in the business, and opening up multiple CD’s is a breeze.  Using 5 yr CD’s is a way to preserve your principal and have your money liquid (within a couple of days).  We think this deserves consideration in everyone’s portfolio.  And while you’re at it, open up 5 year CD’s every year and get your 5 yr CD ladder going!

*We dislike ING because we find their interface to be clunky and are too old to remember all the crap it requires to log on.


12 Responses to “Why you should use 5 year CD’s for your emergency fund”

  1. April 12, 2012 at 11:17 pm

    I love this idea! I actually had my emergency fund in Ally’s 11-month no penalty CD for quite awhile, because I didn’t really trust the 60 day penalty on the 5 year ones.

    I would vote for keeping the first month (or a certain dollar amount) of your emergency fund entirely liquid, i.e. at the bank/credit union where you have your checking account and then the rest in 5 year CDs at Ally.

    My general experience has been that the most money I need at any given time with minimal notice is about $5,000, so I would be pretty comfortable with keeping the rest of the money in CDs at Ally.

    That’s strange that you dislike ING’s interface – I actually far prefer theirs to Ally’s, but I stick with Ally because the rate is better.

    • April 13, 2012 at 5:12 am

      We actually keep half our emergency fund in 5 yr CD’s and the other half in a high yield account. But this summer, we’ll slap another “rung” on our 5 yr CD ladder and we’ll put it all in.

      The equation above also helps people to analyze when to switch if interest rates rise. For instance, if interest rates go up to 3%, how long will it take you to “break even”? We think one day we will probably eat the penalty on a bunch of CD’s to get back in at a higher interest rate. But time will tell.

      The almost 2.5% APR we are fetching won’t make history headlines, but we’ve made much more money than having our money in other “safe” options.

      We can’t ever seem to remember our security questions with ING and it is clunky. They seem to have a bunch of “Variable” questions that we can’t ever get past. Since one of us has lived in 20% of the States in this great country, went to multiple high schools and moved around a lot while a child, some of the questions are either hard to remember or change at various times. It’s one of the few sites we have problems with.

  2. 3 MyMoneyDesign.com
    April 16, 2012 at 6:19 pm

    I’ve been with Ally since they were GMAC. I’ve also found them easier to use than ING. I like the idea of using a 5 year CD. Right now my money is chilling in the Ally savings account and not doing a whole lot. I liked things a lot better when the Ally and ING savings accounts were paying between 3 and 5% about 6 years ago.

    • April 16, 2012 at 8:51 pm

      Don’t we all wish CD’s were fetching 3-5%. I even remember when a high yield savings got 5%. 5 yr CD is the “least bad” option right now if you care about capital preservation and liquidity.

  3. April 18, 2012 at 4:24 pm

    I did this a while ago myself, added a few 5 year CDs at Ally when I could get 2%. We also keep about half our emergency fund in there, and it is broken up over several CDs so that if we do need it, we don’t break just one big one but only the ones we need. I probably won’t add any more however, as one, our emergency fund doesn’t need to be any largers, and two, rates continue to come down on these. 😦

    • April 18, 2012 at 5:58 pm

      Hi Karl. Thanks for stopping by. Unfortunately, 5 yr CDs are the least bad option right now. We hope interest rates come up a moderate amount, but until then, we’ll settle for the highest yield without going up the risk curve.

  4. April 19, 2012 at 11:32 pm

    Great Post 🙂 You got to it before me, but I think as long as Ally has this 2 month’s interest penalty policy, giddy up!

    • April 20, 2012 at 12:22 pm

      But even at 3 months, that is a fair proposition. You can easily modify our equation above by swapping the 2 in the numerator with a 3. So on and so forth. 4 months, probably so. The point is, getting as much returns as you can without going up the risk curve. Thanks for stopping by!

  5. April 30, 2012 at 11:27 am

    This is a very interesting idea. I’ve never thought about doing something like this before. I can definitely see how putting some money into CD’s could earn more interest while still being easily accessible. Thanks for sharing.

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