Life has a way of throwing expensive curveballs.
You want to be prepared.
It’s not a question of if you’ll have an unexpected expense, but rather when — hence the importance of establishing and maintaining an emergency fund.
Some people are old-school and keep their emergency cash under the mattress or in a shoebox. But while this approach keeps funds close, it doesn’t provide the most protection. And it also robs you of any opportunity to earn interest.
The bank is one of the best places for your emergency fund.
Yet, another question remains. Is your cash better in a savings account or a certificate of deposit (CD)?
Learn about the differences of these two common types of bank accounts to see which one is more appropriate for an emergency fund.
The Point of an Emergency Fund
Emergencies don’t happen every day.
So it’s easy to downplay the value of saving for an unexpected expense or a rough patch. You might put it off until your income increases. Or only save a small percentage of your earnings.
But even if you’ve been fortunate thus far, everyone faces an emergency at some point. Not to say you should obsess over situations that might never happen. All the same, having an emergency fund can provide peace of mind.
Car repairs, home repairs, medical bills, and last-minute travel can cost hundreds or thousands of dollars.
If you don’t have enough money in savings, you could end up relying on a credit card to get through these emergencies.
And if you’re unable to pay off your credit card, you’ll pay interest charges for each month that you carry a balance. This makes an emergency even more expensive.
An emergency fund also comes in handy after a job loss. The reality is, there’s no such thing as true job security. Even if you work hard and give your employer 110 percent, you’re not immune to job loss.
If you’re laid off or fired, it might take months to secure new employment. A savings account, however, can help you weather these storms.
What is a Certificate of Deposit?
Keeping emergency funds in the bank is a chance to earn interest on your deposit.
Naturally, you want to get the highest return on your monty. For this reason, you might consider putting your emergency fund in a CD. This is a type of savings account with one primary difference.
Certificate of deposits are also time deposits.
In other words:
You agree to leave your money in the bank untouched for a certain length of time.
CD terms can range from six months to 10 years, on average.
In exchange for leaving your cash in the account, the bank rewards you with a higher interest rate. At the end of your CD term, you’ll get back your original deposit plus interest.
The interest rate on a CD varies, but it’s more than the interest rate on a savings account. The longer your CD term, the higher your rate, too.
But while a certificate of deposit is an attractive product, it might not be the best place for your emergency fund.
Early withdrawal penalties
Remember, an emergency fund should provide quick access to cash for unexpected expenses.
With a CD, you can’t quickly pull money from the bank on an as-needed basis. But you can do this with a savings account.
When you open a savings account, you are given a debit/ATM card which can be used to withdraw money from an ATM. You can also withdraw cash from your savings account inside a branch or transfer funds electronically.
Accessing cash in a certificate of deposit isn’t as simple.
If you want to pull money from a CD, it may take a day or two to access your money. This can be problematic when an emergency arises and you need same-day cash.
CDs are designed for long-term savings. Therefore, the idea is to avoid needlessly dipping into your account. This ensures that you’re able to maximize the growth of funds.
Of course, this is your money. So you’re certainly free to request an early withdrawal.
This involves withdrawing money from your CD before the end of your term. But banks normally impose an early withdrawal penalty, often the equivalent of several month’s interest.
Some banks offer no-penalty CDs.
This allows you to withdraw money early without paying a fee. But while convenient, the downside is that these certificates of deposits come with a lower interest rate. This reduces your earnings and slows the growth of your account.
Why Use a Savings Account for an Emergency Fund?
There’s no rule that says you can’t use a CD for your emergency fund. But a savings account is usually a better option.
A savings account keeps your money liquid so you can access it whenever necessary.
Another benefit of a savings account is that you’re able to open the account with limited funds. Some certificate of deposits require a minimum opening deposit between $500 and $1,000.
If you’re just starting an emergency fund, you may not have this amount of cash available. On the other hand, many savings accounts allow you to open an account with only $25.
Keep in mind that if you withdraw cash from a savings account, you’re limited to a certain number of online, electronic, and telephone transfers.
If you initiate more than six of these transfers in a statement cycle, your bank may charge a fee.
There’s no withdrawal limit when you take cash from an ATM or get cash from inside a branch.
A savings account may seem like the inferior option because these accounts don’t offer the highest rates.
The good news:
You can find better rates with a high-yield online savings account.
To maximize and grow your emergency fund faster, set up regular transfers into your account after each payday. This approach puts your savings on autopilot.
Also, ask your bank about automatic savings programs.
Some banks have a savings round-up program. For every purchase you make with a debit card, the bank rounds up purchases to the nearest dollar and deposits the change into your savings account.
Other banks will deposit $1 into your savings account each time you make a purchase with a linked debit card.
Another option to maximize your return is to skip a savings account and open a money market account. Your money is also more accessible with this type of account compared to a certificate of deposit.
But again, money market accounts limit accountholders to six withdrawals per statement cycle. Plus, opening a money market account may require a minimum opening deposit of $100, $500, $1000, or more.
How Much Should You Keep in an Emergency Fund?
The general consensus is to have a minimum of three to six month’s worth of income in your emergency fund.
But don’t stop saving once you hit this goal. The more you have stashed away for the unexpected, the better.
Understandably, you can only save what your income allows. Be mindful that starting an emergency fund may require a few sacrifices on your part. Some people feel that they don’t earn enough to save.
But the truth is:
Many people do earn enough.
The problem is that they’re living beyond their means.
Initially, you might not be able to save 10 percent of your monthly income for emergencies, especially if you’re also saving for retirement.
In this case, start small and save 5 percent of your income each month, with a goal of gradually increasing your savings deposits over the upcoming months or years.
Re-adjust your budget to see where you can cut back on spending, and then put the savings into your emergency fund.
If you get a raise, funnel the extra money on your paycheck into savings.
You should also save any free or surprise money you receive during the year. This can give your emergency fund a strong boost. Funds might include work bonuses, gift money, and perhaps a tax refund.
There’s no set amount to have in an emergency fund. The bottom line is that some savings is better than none. Do what you can afford. If need be, start by aiming for a $1,000 emergency reserve.
Even though a CD might not be the right match for an emergency fund, you can still open one if you like the idea of earning a higher rate and establishing a long-term savings.
What you can do is keep a percentage of your cash liquid in a savings account at your bank. This account will function as your emergency fund. You can then deposit another percentage of your cash into a CD.
This way, you’re able to enjoy the best of both worlds. You’ll keep some of your cash available for surprise expenses, while earning a higher interest rate on cash you’ll use for future goals.