Having an emergency fund is crucial to protect against financial disaster. Without one, you could find yourself forced into credit card debt when something inevitably goes wrong and you have to spend money you didn't plan to use.
You'll need to decide where to put your emergency fund, though -- particularly since you'll probably want to have a lot of money in this account. Experts recommend having around three to six months of living expenses saved, which could mean the average family needs around $36,486 (based on The Motley Fool Ascent's research showing average monthly expenses of $6,081).
Sticking the funds in a certificate of deposit (CD) may seem attractive because CDs generally tend to pay higher yields than even high-yield savings accounts. But should you keep your emergency money in a CD?
There's a big problem with using a CD for your emergency money
At first glance, CDs may seem like a viable option for your emergency money. After all, they're FDIC insured so you won't risk losing any money when you buy one -- which is important, because you can't afford to lose the money you have saved for surprise costs. And some CDs are paying rates of more than 5% right now, which may be tempting when you have a lot of money set aside.
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There's one big problem, though: A CD is not a place to put money that you could need at any moment. That's because you have to make a commitment when you buy a CD. Each one has a term length, such as three months or two years or five years or some other duration set by the bank that's selling it.
When you buy the CD, you have to agree to leave your money invested in it for the term length to avoid penalties. Sadly, this would mean your funds are no longer available and accessible to you for emergencies -- which is the very purpose of the money in the first place.
Your emergency money needs to be accessible to you at all times
When you save money for emergencies, you should have one single goal for that cash: to be available to you to avoid a financial crisis when unexpected expenses arise. Making the money unavailable by investing in a CD goes against that goal and could force you to either pay a penalty or borrow money if you face a surprise expense before your CD term is up.
A high-yield savings account will pay a little less than a CD and it has a variable rate, so if interest rates fall, you could end up making a far lower return than you would have had you locked in with a CD at today's rates. But those downsides are worth dealing with when the tradeoff is that your funds actually remain available for unexpected expenses.
You can't predict when you'll need to rely on emergency money, so even a CD with a short term could end up locking up your cash for too long. You can use a CD for other short- and mid-term goals when you know you won't need the money for a set time...but your emergency fund belongs nowhere else but a savings account so it's ready when you need it.