You never know when you might need money in a pinch, whether to pay for an unexpected car repair or cover your expenses during a period when you're out of a job. That's why it's so important to maintain an emergency fund -- ideally, one that has enough money to cover three months of essential bills or more.
Many people put their emergency funds into a savings account and call it a day. But you may be interested in keeping a portion of your emergency fund in a CD. And it's easy to see why.
CD rates tend to be higher than savings account rates, so you have an opportunity to earn a bit more on your money. Plus, with a CD, your interest rate is guaranteed for the duration of your CD's term. With a savings account, your interest rate could change for the worse without warning.
But while you may be tempted to split your emergency fund between a savings account and a CD, that's a decision that could backfire on you.
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Why risk a penalty?
If you have a larger emergency fund, you may be able to get away with putting some of it into a CD.
Let's say you've saved enough money to cover six months of living costs. You could keep three months' worth of expenses in a regular savings account and put the rest of your money into a 3-month CD. This way, if you were to lose your job and be unemployed for half a year, you'd have access to your 3-month CD by the time you've blown through the savings account portion.
But you're generally not going to find a CD with a term of less than three months. (Even 3-month CDs can be somewhat hard to find). And so if you only have a three-month emergency fund, you're going to want to keep all of it in a savings account.
Most banks charge a penalty for cashing out a CD before it matures. The exact penalty depends on your bank. An example from one of the big banks is three months' worth of interest for an early withdrawal of a CD with a term of 12 months or less. But if your goal in keeping some of your emergency fund in a CD is to earn more interest, you could end up losing way more than what you'd gain by virtue of an early withdrawal penalty.
Say your emergency fund comes to $6,000, and you put $3,000 of that into a 3-month CD to earn 5.00% APY on your money instead of the 4.00% APY your savings account is paying. Over those three months, that's an extra $7.50 in interest. But if you're forced to cash out that CD early, you stand to lose $37.50 if you're looking at a penalty of three months of interest. That's just not worth the risk.
It may be best to play things safe
The whole purpose of having an emergency fund is to give yourself peace of mind. Why mess with that by putting some of your cash into a CD and running the risk of having to take a withdrawal prematurely?
It's great to save money on top of your emergency fund so you can take advantage of higher CD rates. But you should probably keep your entire emergency fund in a savings account to avoid potential stress and the risk of penalties.
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