We all know that we need an emergency cash reserve for life’s “what-if” events, such as job loss, car repair or illness. However, the idea of setting aside money for something that may never come to pass isn’t exactly appealing. This is particularly true when it means stashing the money in an account that earns next to nothing in interest.
As a rule of thumb, financial planners suggest that people keep at least three to six months of living expenses in a cash reserve. Since the money needs to be available on short notice, you should focus on safety and liquidity. In this context, safety means that the money should not be exposed to risk (such as invested in the stock market) and liquidity means it should be there when you need it (forget CDs, with their early termination fees and lock-ups).
So where can you stash this cash if you want both safety and liquidity, and to earn at least some interest? Here’s a look at four options:
1 A money market fund. This is offered by a brokerage firm such as Schwab, Vanguard, etc., and is a strong option, although it comes with a caveat. Money market funds are not insured by the Federal Deposit Insurance Corporation (FDIC), an independent agency of the U.S. government. That being said, these are very, very conservative accounts and have little volatility. In fact, it is my favorite option for housing short-term emergency cash because it strikes a great balance of risk and reward in this context.
2 An FDIC-insured account. At most banks, both online and brick-and-mortar, money held in money market accounts, savings accounts, checking accounts and CDs are FDIC insured. In the unlikely event that the bank goes bankrupt, the government guarantees your deposit up to a certain amount. In return for this added safety, interest is lower than in a money market fund. If you lean more on the conservative side, this might work for you.
3 A mix of an FDIC-insured account and a conservative portfolio. Put a portion of the cash reserve in a savings account and the remainder in a mix of ultra-short-term taxable and municipal bond funds. In this scenario, some of the money is guaranteed by the FDIC and the remainder involves some risk but can earn more than you can get at banks. However, there will be mild fluctuations in value on the bond portion, so you must be comfortable with that.
4 A home equity line of credit. If you really hate holding cash, you can consider a home equity line of credit, which allows you to tap some of the value in your home. However, there are closing costs and you have to pay interest on the loan. This is my least favorite option because it costs you money to access your emergency reserve, which, of course, you should avoid.
At the end of the day, the option that works for you will come down to your personal preference and unique financial situation. Regardless of the strategy you choose, make sure to have a plan in place so you can access money when you need it.
JASON E. SIPERSTEIN, CFA, CFP, is the president-elect of the Financial Planning Association of Rhode Island and vice president of Eliot Rose Wealth Management. He can be reached at email@example.com.