September 29, 2023 8:32 pm
September 29, 2023 8:32 pm

How to upgrade your emergency savings with measured risk

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Emergency savings are essential for anyone who wants to be prepared for unexpected expenses or income loss. However, keeping your emergency savings in a checking account or savings account may not be the best option, as these accounts typically earn little to no interest. This means that your emergency savings are losing purchasing power over time due to inflation. For readers who still use a traditional savings account for their emergency savings, this could be a good opportunity to upgrade your emergency savings!

Fortunately, there are other financial products that can offer a higher yield without exposing your emergency savings to high degrees of market risk. Market risk is the possibility of losing money due to fluctuations in the value of your investments. You don’t want to take on significant risk with your emergency savings, because you may need to access them at any time, and you don’t want to sell them at a loss.

Financial products that you can consider for your emergency savings

In this blog article, we will list out some of the financial products that can help you upgrade your emergency savings by taking on measured risk. Measured risk is the amount of risk that you are comfortable with and that matches your financial goals and time horizon. We will also discuss the pros and cons of each product and how you can use them together to create a portfolio that suits your needs.

Government Bonds

These are inflation-protected bonds issued by the US Treasury that pay a fixed interest rate plus an inflation adjustment every six months. The interest rate is usually higher than a savings account and the inflation adjustment helps preserve your purchasing power. You can buy I Bonds online through TreasuryDirect.gov with a minimum of $25 and a maximum of $10,000 per year. You can redeem them after one year, but you will lose three months’ interest if you redeem them within five years.

Pros

  • Safe
  • Tax-deferred
  • Inflation protected

Cons

  • Low liquidity
  • Low annual limit
  • Penalty for early redemption

Laddered certificates of deposit (CDs)

These are deposits that you make with a bank or credit union for a fixed term and interest rate. You can choose different terms ranging from a few months to several years, depending on your preference. In normal times, the longer the terms provide a higher interest rate. However, you cannot withdraw your money before the term ends without paying a penalty. Today there is an inverted yield curve, so the shorter-term CDs actually pay a higher interest rate! To create a laddered CD portfolio, you divide your money into equal parts and invest them in CDs with different terms. For example, if you have $10,000, you can invest $2,000 in a 6-month CD, $2,000 in a one-year CD, $2,000 in an 18-month CD, and so on. This way, you have some money maturing every year that you can either reinvest or use for emergencies.

Pros

  • Higher interest rates than savings accounts
  • FDIC insurance up to $250,000 per depositor per institution,
  • Predictable cash flows. The cons are that they have low liquidity, may have minimum deposit requirements, and may lose value if interest rates rise.

Cons

  • Low liquidity
  • Minimum deposit requirements
  • Less valuable when interest rates rise
  • Some CDs may be callable

Short maturity US treasuries

These are debt securities issued by the US government. They include treasury bills (T-bills), treasury notes (T-notes), and treasury bonds (T-bonds). These securities are structurally the same with different nomenclature based on the time to maturity. Treasury bills, which mature in a year or less, pay a fixed interest rate at maturity and are sold at a discount from their face value. For example, if you buy a $1,000 T-bill for $990 and hold it until maturity, you will receive $1,000 and earn $10 in interest. You can buy US treasuries online through TreasuryDirect.gov or through brokers or banks with varying fees and minimums. You can also sell them before maturity in the secondary market if you need cash.

Pros

  • Safe – considered by many to have no credit risk
  • Very high liquidity
  • Generally exempt from state and local taxes The cons are that they have low interest rates compared to other products and are subject to federal taxes.

Cons

  • Lower interest rates than riskier assets of the same maturity like commercial paper
  • Unlike municipal bonds, treasuries are subject to federal taxes

Commercial paper for highly rated companies

These are short-term debt instruments issued by corporations to finance their operations or meet their short-term obligations. They typically mature in less than 270 days and pay a fixed interest rate at maturity. They are sold at a discount from their face value and are unsecured, meaning that they are not backed by any collateral. You can buy commercial paper through brokers or dealers with varying fees and minimums. You can also sell them before maturity in the secondary market if you need cash.

Pros

  • Higher interest rates than US treasuries
  • High liquidity

Cons

  • Higher credit risk that is dependent on on the issuing company
  • Subject to federal, state, and local taxes

High yield savings accounts

These are online savings accounts that offer higher interest rates than traditional savings accounts. They are offered by online banks or fintech companies that have lower overhead costs than brick-and-mortar banks. They typically have low or no minimum balance requirements, no monthly fees, and no withdrawal limits. You can access your money anytime through online transfers, ATM withdrawals, or debit card purchases.

Pros

  • Higher interest rates than traditional savings accounts
  • FDIC insurance up to $250,000 per depositor per institution

Cons

  • Interest rates typically lower than than the aforementioned CDs, treasuries, and commercial paper
  • Variable interest rates that can change at any time

How to use these products together to upgrade your emergency savings

There is no one-size-fits-all solution for your emergency savings portfolio. You should choose the products that match your risk tolerance, time horizon, and financial goals. However, here are some general guidelines that you can follow:

  • Keep at least three months’ worth of living expenses in a high yield savings account for easy access and liquidity. This is your primary emergency fund that you can use for urgent and unexpected expenses.
  • Invest the rest of your emergency savings in a mix of I Bonds, laddered CDs, short maturity US treasuries, and commercial paper for higher returns and inflation protection. This is your secondary emergency fund that you can use for less urgent and more predictable expenses.
  • Diversify your portfolio across different products, issuers, maturities, and interest rates to reduce your risk and optimize your returns. For example, you can allocate 25% of your secondary emergency fund to each product category or adjust the percentages according to your preference.
  • Rebalance your portfolio periodically to maintain your target allocation and take advantage of changing market conditions. For example, you can reinvest your matured products into new ones with better rates or terms or withdraw some money from your secondary emergency fund to replenish your primary emergency fund if needed.

By following these steps, you can upgrade your emergency savings by taking on measured risk and earn more money without sacrificing your safety and security.

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