savings

Financial Literacy Guide: Building an emergency fund

Financial experts recommend that we have a minimum of three months worth of living expenses set aside in case of an emergency. A cash crisis can be as major as losing your job to a more minor, but unexpected event such as a car repair. You don't want to pull out a credit card to tide you over in an emergency unless you can pay it off in the next billing period. Otherwise, by the time you pay the interest, which grows daily, you can easily end up spending more than double the original cost.

Bankrate.com's personal finance expert Dr. Don offers tips for where to stash your cash to earn a better yield, plus how to calculate the size of your savings.

How large should my emergency savings be?
Most experts suggest three to six months' worth of living expenses for an emergency fund. The idea is that you'll have enough cash on hand to see you through a fiscal emergency, such as a period of unemployment or a bout of poor health.

Where can I invest my emergency fund for the liquidity of a savings account, but a better interest rate?
There are a couple of approaches to minimize the loss of interest income on the emergency fund. One is to invest it in longer-term securities and accept some risk if you need to cash in. For example, you could invest in a five-year CD and accept the interest penalty if you had to cash in. The example below shows how by comparing interest earnings from the first year:

Comparing interest earnings
 Five -year CDMMA
Investment$15,000$15,000
Interest rate*2.89%0.46%
Annual interest$434$69
Six-month interest penalty$216.60n/a
*Bankrate averages from March 31, 2004

You're picking up an extra $365 a year in interest and risking $216.60 if you have to cash in early. Unlike investing in bonds, you aren't facing price risk if interest rates go higher. Non-negotiable FDIC-insured CDs don't face price risk, just early withdrawal penalties.

Penalties for early withdrawal vary by bank, so make sure you know the early withdrawal penalties for the CD you invest in before you decide on this strategy. This Bankrate feature discusses early withdrawal penalties in greater depth.

Alternately, you could invest in a laddered CD portfolio where you have a CD rolling off every six months.

Bond mutual funds are another alternative. You can choose the average maturity, credit risk and even investing in tax-free municipal bond funds. I don't think they're as good a choice for your emergency fund because the investment decisions and capital gains management are left to the mutual fund manager.

You could be taking on more price risk than you envisioned, if interest rates trend higher. (When interest rates go up, bond prices go down.) Bond funds often aren't very tax efficient, creating tax obligations that are outside your control.

Ultra-short and short-term bond funds have less price risk than an intermediate term bond fund because their short-term holdings aren't as volatile. An ultra-short fund will have an average maturity of about six months. Stay away from bond funds that invest in non-investment grade bonds because of the credit (default) risk.

What are the risks of using certificates of deposit or savings bonds as my emergency savings vehicle?
Investors are much more willing to invest short-term than long-term. The resulting availability of short-term funds keeps short-term rates lower than long-term rates. This liquidity preference gives the yield curve its normal, upward-sloping shape.

Ideally, you will never need these emergency funds. You'll keep these funds invested short-term over the long term just in case a financial emergency crops up. What you gain by investing in this manner is a guarantee that the principal will be there when you need it. Your loss is the additional investment income these funds could have generated if they were invested elsewhere.

Be willing to take on some risk in your emergency fund investments, and you'll pick up some yield while keeping principal safe and available. One way to do this is to buy longer-term certificates of deposit and accept the risk that you'll have to pay an interest penalty if you need access to your funds. You may lose three to six months' worth of interest, but you're not putting principal at risk. Not all financial institutions have the same early-withdrawal provisions. Know the provisions before depositing the funds. This Bankrate feature discusses early-withdrawal penalties in greater depth.

You can do something similar with savings bonds. There's an interest penalty if you cash the bonds in within five years of issuance. The penalty is to lose the last three months' worth of interest income. An added benefit to this approach is that the interest income on savings bonds isn't subject to state or local taxes, which improves your after-tax yield.

An alternative to Series EE savings bonds are the Series I savings bonds, which provide inflation protection. Series EE bonds currently yield 2.61 percent while the Series I bonds currently yield 2.19 percent.

One shortcoming with savings bonds as an emergency fund investment is that you can't redeem them during the first six months of ownership. And the government is extending this minimum holding period to one year effective with bonds issued as of February 1, 2003. If you took this approach, you would want to purchase these bonds over time, so you would have some funds liquid while waiting for the initial purchases to age to the point where they could be redeemed. The U.S. savings bond Web site provides you with all the details of ownership in its Savings Bonds Owner's Manual.

An ultra short-term bond fund or short-term bond fund are alternatives to money market investing or the CD or savings bond options presented here. There's less price risk in a short-term bond fund than in a long-term bond fund, but you're still risking principal if interest rates start to move higher. That's because bond prices fall as interest rates rise.

With short-term and ultra-short-term funds you're falling off a step instead of falling off a cliff. Funds invested in corporate bonds should return more than funds invested solely in government bonds, but you're taking on more risk.

Don't forget to consider tax-exempt investments. The higher your federal income tax bracket, the more these funds make sense. Look at the tax equivalent yield to see how you'd do when compared to a taxable fund.

Find a level of risk you're comfortable with among these choices. Be willing to accept a little more risk in your emergency fund investing, and you can expect to pick up higher returns.

To hedge against a loss of principal, have a bigger emergency fund than you expect to need. Many financial planners recommend that your emergency fund represent three to six months' worth of expenses. If you're going to take on some additional risk to attempt to increase the return on these investments, then increase the size of your fund by 15 percent to 25 percent.

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