An emergency fund is money you save up that can be used to offset unforeseen financial problems or challenges (think serious car repairs, sudden unemployment, etc.). An ideal emergency fund is both liquid and covers three to six months worth of living expenses. Once you acquire an appropriate amount, the next question is where to maintain it. Most people would naturally gravitate towards placing it all in a personal savings account. As a matter of fact, I used to keep my entire emergency fund in savings until I realized just how low my current annual rate of return was. As a result, I searched for better ways to diversify with different and safe investment platforms in order to garner a greater yield of return. Two alternatives to spice up your emergency fund are through US Government I Savings Bonds and CD ladders.
US I Savings Bonds
I Bonds are securities that earn interest based on a combination of a fixed interest rate and an inflation rate. Because the bonds adjust for inflation, you are guaranteed that your purchasing power will never decrease. The variable inflation rates are adjusted twice a year with interest compounding semiannually. While current rates are low for I Bonds, you will still earn more than a typical savings account. Some things to consider--you cannot redeem an I Bond until after one year. Interestingly enough, this restriction is waved if you have been affected by certain natural disasters. In addition, you will lose the last three months of interest if redeeming an I Bond before it turns five years old. Once the bond matures past five years, however, you can cash in penalty free. I Bonds are bought at face value and can be purchased electronically through the government's TreasuryDirect.gov website.
CD Ladders
Bank CDs normally carry higher interest rates than a savings account. The lack of liquidity sometimes causes investors to shy away, yet higher rates are typically found with longer-term CDs. By laddering your CDs, however, you can earn the better rates and improve liquidity. CD ladders work as such--with $3,000, place $1,000 each into a one-year, two-year, and three-year CD. Once the one-year CD matures, buy another three-year CD. Lather, rinse, repeat! By doing the same thing each year, you should earn higher yields overall by purchasing the longer-term CDs. Of course, there are penalties for cashing in a CD before the maturity date. Do your homework first to decide how the interest penalties will affect early withdrawal. Check your local bank or banks online for the best rates and more information.
Diversification That Works for You
If you do decide to diversify your emergency fund, make sure you are comfortable with the plan and understand all associated risks. By dividing your fund into three parts--say 50% Savings Account, 25% I Bonds, 25% CD Ladders--you should see improvements to your overall rate of return while protecting the principle. Think of your emergency fund as an investment. Like all investments, it too needs to generate additional revenue until called into action.
Disclaimer
I am not a professional financial manager, just someone interested in taking charge of my own money. I currently maintain 80% of my emergency fund in US I Bonds. Please conduct your own research before investing.
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