One of the most common pieces of financial wisdom is to have an emergency fund. Dave Ramsey lists it as his first Baby Step.
Businesses have from the beginning of time required working capital to function as a successful enterprise.
Investment property owners have maintenance accounts and all these groups frequently employee a sinking fund. (A sinking fund is an account segregated for use in replacing a wasting asset such as a car. The maintenance account many landlords keep is really a sinking fund for eventual required expenditures like a new roof or furnace.)
There is a reason the emergency fund — and her close cousins the sinking fund, maintenance account and working capital account — is such a widely held belief. Without the capital needed for extraordinary expenses you risk financial hardship when a large expense arises.
There is another advantage to having these accounts: avoiding the need to borrow at an unexpected times. Business owners understand the advantage of having adequate working capital. They also understand that a financial cushion is more than just a convenience in business. Adequate working capital can remove or eliminate the need to borrow under extreme situations.
The best part of an emergency fund is that you get paid a token amount of interest as you wait for the inevitable versus paying interest because you didn’t plan accordingly. This affects profits.
As good as the advice is to keep a cash cushion for irregular large expenses, one question is rarely answered: Where do you store the money?
For micro-sized accounts most people employee a simple bank account or keep the money in a sock drawer. This creates a set of new problems.
Banks (and credit unions more and more often) don’t look kindly at small accounts. They act as if an account in their computer with $867.12 in it is creating a massive financial burden to their financial institution. Accordingly, they pay almost nothing (sometimes even nothing) in interest to these accounts. Worse, they may charge fees just for having the account!
That forces some people to use the sock drawer. The sock drawer has even more problems. With the money so close at hand it is easier to spend, destroying the best laid plans of. . . ah, you know. If you and everyone in your household has the fortitude to keep their paws off the stash one problem remains: theft. Keeping your emergency fund in cash risks theft or loss in a fire.
And that is where the story usually ends. The advice — keep an emergency fund — is wonderful advice if you were provided options beyond “keep it in the bank or under the mattress.”
Options for Storing your Emergency Funds
What other options are available to store short-term money? The bank is okay when you’re first starting out, but once the balance grows even a little it would be nice if your emergency funds pulled its own weight by earning at least a token amount to mitigate the affects of inflation.
There are actually a large number of tools available for investing your emergency fund, working capital, sinking fund and maintenance account that pay you for saving your money there.
Before we discuss the alternatives we need to set some guidelines on what characteristics our alternatives must have.
- The investment must be liquid.
- The investment must be easily accessible within a few days or sooner. We don’t want the money too easy to access as it might allow temptation to creep in, but not so far away we can’t get it when needed.
- The investment must be safe. Guaranteed accounts are nice, but not required. Still, safety of capital is always the highest priority in such accounts.
- The investment must have a return (reasonable interest rate).
- Should be easy to set up.
- The investment should have low or no minimum balance requirements.
- The investment must have the option to make regular additions in small amounts.
Alternative Emergency Fund Accounts
Following the rules outlined above, here is a list of alternative investments for storing your emergency funds and similar monies:
A decade ago this was my go-to account for working capital in my tax practice. I couldn’t get a higher safe return anywhere else. That has changed, but is now swinging back onto the radar.
When the Fed lowered interest rates to zero it was hard to justify using Treasury Direct. However, with short-term Treasuries now sporting over 2% it might be an alternative worth exploring.
Treasuries are the safest investment on the planet. Not many investments can say they are guaranteed. Treasury securities, some insurance and bank products are the only investments that can claim they are “guaranteed”. And U.S banks and insurance companies are insured by the government so it’s back to Treasuries providing the only real guarantee out there.
The U.S. government has put considerable effort into providing a powerful cash management tool. Let’s run down a few of the options available from Treasury Direct:
You can buy Series EE and I savings bonds on Treasury Direct. The Series EE bonds are a poor investment only paying .1%. Maybe they think they are a bank. (All references to yield are from the day of publication: May 5, 2019. Use links to review current yields on investments discussed in this post.)
Series I savings bonds are a different story, however, paying 1.9%. The Series I is an inflation adjusted bond. If inflation picks up, your interest rate increases. (And declines if inflation declines.)
The best part is you can invest with as little as $25 and increase your investment by any amount above that.
There are no fees for using Treasury Direct or buying and selling on Treasury Direct.
Treasury Bills, Bonds and Notes
We should differentiate between these types of Treasury instruments before continuing:
- Treasury Bills are very short-term instruments with a one-year or shorter maturity. Since we are discussing emergency funds, this may be the most appropriate use for the accounts we are discussing. Bills are sold at a discount and pay in full at maturity. (Example: a Treasury bill with a one-year maturity and slightly more than a 2% return will sell for $980 and pay out the full $1,000 at maturity, which includes the interest.)
- Treasury Notes have a 2 – 10 years maturity date from issuance. Landlords with maintenance accounts may find Treasury notes a powerful tool in planning for long-dated maintenance and improvements. Example: a roof with 10 years of life left can be slowly funded first with Treasury notes and finally with T-bills. The interest on the notes will pay out every six months and can be reinvested.
- Treasury Bonds have a maturity date in excess of 10 years from the issuance date. While these long-dated instruments are excellent tools for many investment goals, the T-bond is not the most appropriate tool for emergency funds or working capital. (And also carry the greatest risk of loss if you need to sell the bond prior to maturity. If interest rates climb, long-dated bonds decline in value. They pay in full at maturity, but selling prior to maturity does not guarantee a gain.)
For our discussion Treasury bills will be the most used. T-bills can have a maturity date as short as a few days. You can keep rolling the investment for as long as you want. Your money is only a few days from maturity and easy access at any time.
You can also ladder your emergency fund or maintenance account. I used T-bills in the past to manage working capital in my firm. High revenue in spring was invested with some maturing rapidly and some maturing later in the year when revenue was low and year-end expenses climbed. This allowed for a maximum return on my liquid funds.
T-notes and T-bonds also have low entry points, being purchased in $100 increments with $100 as the minimum.
There is one last Treasury to consider: TIPS (Treasury Inflation-Protected Securities). As the name indicates, these Treasuries provide protection from increasing inflation. As inflation (not to be confused with interest rate changes) changes, so do TIPS. TIPS pay a set interest rate for the life of the bond, but the bond increases in value by the recent inflation rate (they are guaranteed to never decline if there is deflation). This means your interest earned keeps climbing as the value of your bond grows over time. At maturity TIPS pay out the entire inflated value of the bond. (Note: Interest paid out and inflation increases accrued to the bond’s value are all currently reported interest income for tax purposes.)
TIPS come in 5, 10 and 30 year maturities and pay out interest every six months.
It wasn’t long ago when money market accounts paid about what banks did: nothing. With the Fed Funds rate at 2.5% things have changed.
I use Vanguard’s Prime Money Market Fund for personal and business cash management needs currently. It is easy to use and funds are always accessible. The rate as of this writing is 2.47% compounded annually.
The biggest issue for some people is the $3,000 minimum to start. (I allowed my account to drop below $3,000 after opening without issue.) You can add and withdraw almost any amount at any time once you meet the minimum to open the account.
If your emergency fund is really small Treasury Direct might be the best option. For everyone else, the ease of using Vanguard trumps the very, very small interest increase from using Treasury Direct.
Capital One 360, Discover Savings and Similar Accounts
Keep these options in the back of your mind in case things change (and they always do).
There are several additional similar style accounts. I’ve noticed several advertise on this blog whenever I discuss such topics. Always do your due diligence before committing. The highest rate only makes sense if it serves your needs safely.
Thinking Outside the Box Options
Back in the old days there was a guy called Charles Givens. He was the financial guru circa 1990. (I have an autographed book of his on my bookshelf.) One of his claims to fame was to reduce your insurance to save money and use credit cards if you had a loss. He was sued for that advice according to Wikipedia and a certain accountant’s memory.
As bad as the advice was, it still had a kernel of truth behind it. Over-insuring is expensive and damaging to your wealth. Having a high deductible on your car insurance is worth considering. Credit cards today have cash-back rewards and bonuses. Properly structured, some readers may find value in the old strategy.
As much fun as this strategy sounds, I’m not the biggest fan of using credit cards as your emergency fund. It just sends a shiver up my spine. I would rather use sound financial principles to reduce and eliminate debt.
But this does bring up another outside-the-box idea to maximize your emergency fund returns.
This idea only works if you have debt and you own your home. The goal is to reduce debt whenever possible.
Instead of having an emergency fund (working capital account, maintenance fund, sinking fund, et cetera), plow the amount destined for the emergency fund into paying down your mortgage. When you need the funds back, use a line of credit (HELOC).
Let me illustrate:
You start with a mortgage of $100,000 (or whatever amount your situation dictates). You plow emergency fund and similar monies into reducing your mortgage.
You open a home equity line of credit so the money is available when or if needed. If you draw from the HELOC you now divert your regular emergency fund investments from paying off the mortgage faster to paying off the HELOC.
Since your mortgage and HELOC probably have a higher interest rate than the options I listed above you are better off using your debt as a tool to reduce your debt faster.
Of course, this all assumes you qualify for a HELOC and is based on your mortgage and HELOC interest rates. You also want to consider the HELOC rate further. If the rate is lower than your regular mortgage you might want to move some of the regular mortgage to the HELOC to benefit from the lower interest, depositing emergency fund money to the HELOC, freeing credit limit for emergency uses.
Caveat: HELOC interest rates float. This means the interest rate can change from month to month. The HELOC is not the replacement for the traditional mortgage.
There are choices outside of banks for storing your short-term capital. It doesn’t always have to be an emergency fund either. Keeping some powder dry for an investment opportunity is a smart move. Getting something while you wait isn’t bad either.
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