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Is My Emergency Fund Too Big?

A reader writes in, asking:

“We’re in an unusual position: We have no debt (including no mortgage), no kids, and live well well below our income. Should everything extra go into investments? I don’t suppose it’s reasonable to say I have $100K in an ’emergency fund’?”

Unless your bank is paying you an unusually high interest rate*, I don’t see a lot of benefit to keeping a six-figure sum in cash. Even if you have a very low risk tolerance and are on pace to meet your goals with modest returns, there are a handful of investment options that are very low risk and likely to earn more than typical savings/checking accounts.

CDs, for example, can be a good choice. Allan Roth has often written about finding long-term CDs with low penalties for early redemption (e.g., Ally Bank’s CDs). That way you can get the (relatively) high yield of a long-term CD while still being able to break the CD to reinvest the money at a higher rate if rates rise. And if you stay under FDIC limits, credit risk is virtually zero.

Or, as we discussed recently, I Bonds are currently guaranteed to keep up with inflation (before taxes, that is). Like CDs, I bonds have basically no credit risk. And because you redeem I Bonds directly rather than selling them on the secondary market, there’s basically no interest rate risk either.

A TIPS fund can make sense in some cases, but the downside here relative to I Bonds is that the (inflation-adjusted) yields are negative all the way out to 20-year maturities (as of 4/5/13). And if you go further out along the duration spectrum, you take on significantly more interest rate risk.

We’re in an odd place these days where the distinction between emergency fund and normal bond holdings is becoming rather blurred, given that the typical emergency fund candidates (e.g., CDs, I Bonds) have yields roughly as good as (and sometimes even better than) the typical choices that would be used for the bond portion of a portfolio.

*My favorite place to shop for rates is the Deposit Accounts website. I often find that they have a more thorough collection of rates than many other sites that appear to primarily just pitch banks that pay a commission.

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  1. I think of our emergency fund [almost] like insurance, we’ve always had one and fortunately have never had to exhaust it. People should look at their needs from time to time, like all areas of your financial life, things change. For example, 23 years ago we bought a house [our first, and only] which was in very good condition, including a year old kitchen, and almost all new appliances. We stretched a little to pay 20% down and avoid PMI, which left us with a smallish emergency fund, but since we didn’t expect a lot of home/appliance repairs we were comfortable with that. Over the years we have made some major upgrades, but many of our appliances are now much older than average [we tend to repair, not replace]. At the same time we have let our emergency fund grow [by adding to it regularly], and we are comfortable with knowing that if we need to make several major repairs/replacements in a short time frame, we will not have to dip into our retirement funds. I have read articles that say you don’t need a separate “emergency” fund after you retire, but we like having it separate. We absolutely do not worry about trying to maximize the return on this money, although a fraction of it is in a credit union CD.

  2. On CDs, to avoid or lessen the penalty for early withdrawal, you may want to consider breaking your deposit into several smaller CDs. That way if you don’t have to break a big CD for a smaller expense. E.g. with Ally Bank, I invested $100,000, but I bought ten $10,000 CDs instead of one $100,000 CD. That way, I suffer a 60 day interest penalty only on one $10,000 CD if I need to dip into my fund for, say, a $5,000 expense.

  3. Mike, Is it wise to using ROTH as an emergency fund ? I mean, after hitting my emergency fund target (lets say $30K) would it be dumb to fund the ROTH (both my wife and me) to the maximum of $5k each since we can withdraw contributions anytime.!?

    I would like to use a taxable account for my investments too but I would like to fund my ROTHS and my 529s first. What you think? As always thanks for your time.

  4. SJ,

    I think it can make great sense to do that, provided that the emergency fund money in the Roth is put in something low risk. My wife and I made Roth contributions (and kept the money in Vanguard’s short-term Treasury fund as emergency fund money) for two years while my business was getting off the ground and income was scarce.

  5. I maintain an emergency fund equal to one years worth of budgeted expenses including insurance and taxes. After that is fully funded, I have separate deposit accounts for a future replacement for my vehicle, travel expenses and home improvement. These accounts, in which the yield is secondary to safety and liquidity, amount in total to about ten percent of my net worth. I like sleeping well at night.

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