Dear Dr. Don,
My wife and I have $10,000 in an online savings account with a variable interest rate currently at 3.75 percent annual percentage yield, or APY. This is our "emergency fund."
Should we leave the money here, or open an online short-term CD with an APY of approximately 5 percent? Do I automatically take the one with the higher APY, or is there a general rule to follow when comparing the two?
-- Jonah Jumps
You should be concerned about three things in how your emergency fund is invested: safety, convenience and yield. Banks accounts and CDs both are FDIC-insured, so you've pretty much covered the safety issue. That leaves you to consider convenience and yield.
Emergency funds are most often invested in conservative liquid investments. This keeps them readily available and eliminates any risk to principal.
The downside to all this is that you've got money invested short-term at relatively low yields. That's why consumers often look for an alternative to low-yielding money-market accounts and money-market mutual funds.
One alternative is to invest in a term CD instead of a money market account. Most CDs allow you to pay a penalty for early withdrawal if you need to redeem the CD. If you don't need the money, you get the yield pickup on the investment. If you do need the money, you accept the cost of the prepayment penalty.
An extra 1.25 percent on $10,000 over a year's time is $125 in pre-tax interest income.
Review a bank's CD prepayment penalties and decide if you're comfortable with the risk. Splitting the investment between the money market account and a CD would allow you to fine-tune your approach to liquidity in your emergency fund.
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