The importance of a fully funded emergency fund can’t be overstated. A rainy day fund acts as a safety net when unexpected expenses arise, and it gives you freedom from living paycheck to paycheck. The problem with most emergency funds, however, is that they are stuck in low interest bearing bank accounts. While there are high interest savings accounts, “high interest” today means a miserly 1% to 2%, as this list of accounts on Dough Roller shows.
If frugal spending is spending less, then frugal saving is saving more with the money you have.
And that brings us to CD laddering. While a certificate of deposit is a great way to build an emergency fund, there’s one big downside — penalties for early withdrawal. One way around this is to put your money in short-term CDs, but then the interest rate you get is really low. And while long-term CDs (3 to 5 years) pay higher interest, we’re back to the early withdrawal penalty problem.
CD laddering can solve this problem, and it’s really simple to implement. The idea is to spread your emergency fund savings over several different CDs with high yield rates. So rather than putting all of your savings in a 5-year CD, put 20% in a 1-year CD, 20% in a 2-year CD, 20% in a 3-year CD and so on up to 5 years. When the 1-year CD matures, roll it over into a 5-year CD, and continue this approach each year. Eventually, your entire emergency fund will be in 5-year high yield CDs, with one CD maturing every 12 months. With this approach, you’ll get the benefit of the higher 5-year CD interest rate, but also have penalty free access to some of your money every 12 months.
One objection to this approach is that 12 months is still a long time to wait for your money. Fortunately, there are several creative ways to deal with this problem.
- The first is to ignore it! True, you risk paying a penalty for early withdrawal, but this may be a risk you’re willing to take for higher rates.
- A second option is to start with a 3 or 6-month CD, rather than a 12-month CD. Most banks also offer 18-month and 30-month CDs, so you have a lot of flexibility and can set up a CD ladder with CDs that mature every 3 to 6 months.
- The third solution is a no-penalty CD. As the name suggests, there is no early withdrawal penalty if you take you money out early from a no-penalty certificate of deposit. Ally Bank offers a no-penalty 9-month CD that pays a competitive rate. You can use this CD for 20% of your emergency fund rather than a 1-year CD. With this approach, you always have access to some portion of your money without a penalty. And of course, you can always decide to keep more than 20% of you emergency fund in a no-penalty CD.
Whatever options and combinations you choose, a CD ladder can be a great way to maximize the return on your emergency fund.