In Part 1 of “Emergency Accounts” we discussed their value and the role they play in both the climb out of debt and a post-debt lifestyle.
But regardless of where you are on this spectrum, at the end of the day, you need to pick an account and start funding it.
In this post, I’ll go over the same types of accounts you’ll hear thrown about in conversation with friends, family, local bankers, and investment types…but the difference is I’ll show you how they stack up side by side, so you can make your own decision about where to start building your emergency account today.
Like most things in the financial services industry, clarity can be hard to come by. Even when you’re looking for the most basic of accounts, there is always some amount of spin and plenty of half truths.
Let’s first establish what makes for a solid emergency account:
- Zero Risk (not moderate, not low – zilch!): If the financial markets crashed tomorrow, the balance of your account should be the same as it is today
- Easy Access: You should be able to withdraw funds immediately or at least move them to an account that you can withdraw from quickly (within a day or two).
- Limited / No Fees: You should not incur fees for withdrawals, low balances, or – especially – maintenance.
- Automatic Transfers: An emergency account is only of value if there is something in it. If it isn’t easy to set up an automatic funding plan (weekly or monthly), it will likely never have more than the initial deposit in it.
- Returns: This is a bonus; all other points above come first. When those requirements are met, then look for the best rate of return.
Now that we know what we are looking for, let’s take a look at our options…
Standard Savings Accounts
These plain jane savings accounts are what you will find at your local bank or credit union. Here is how they stack up to our requirements.
- Risk: These accounts are insured by the FDIC (banks) and NCUA (credit unions) up to $250,000.
- Access: Whether you set up one of these accounts at your current bank or one down the street, access is usually just an online click away.
- Fees: Now there is usually a free savings account with every bank or credit union, but make sure they don’t persuade you into another savings account (these usually end in plus, preferred, gold, platinum, etc.) with promises of more flexibility. All you need is a place to park your dough and add to it over time.
- Transfers: Any bank or credit union worth its salt allows you to set up automatic recurring transfers from a checking account to a savings account, whether it is with them or someone else.
- Returns: Don’t expect much (we are talking fractions of a percent these days). Also, the larger the bank, the worse the interest rate (generally).
High-Yield Savings Accounts
High- yield savings accounts were made popular back in the early 2000’s by ING Direct (now CapitalOne 360) when they pushed their online-only banking services in the US market. ING and others lured in customers that were hesitant to deposit in online-only banks by offering significantly higher-yielding savings accounts than the traditional brick-and-mortar banks. Today, the yield gap has narrowed, but it can still be as much as double your local branch bank or credit union.
- Risk: These accounts, like traditional banks, are insured by the FDIC up to $250,000.
- Access: The higher-yield accounts are typically online only, even if offered by a brick-and-mortar bank, like Capital One. You can mail in checks if you like and even take pictures of them to deposit them directly into your account, but most of the time you will just be transferring money from your primary checking account to one of these savings accounts.
- Fees: High-yield accounts usually have no maintenance fees and minimal fees if you go over their withdrawal per month/year limit. If you are are using these types of accounts for only REAL emergencies, then you should never hit their limits.
- Transfers: High-yield banks are built for easy and automatic recurring transfers from your checking account (wherever that is) to your account with them.
- Returns: Almost always better than a traditional bank, but don’t expect to even come close to beating inflation at current rates.
Certificate of Deposit Accounts
Before the era of online banks and their high-yield checking accounts, CDs were the original way to access high-yield interest. And, like the checking accounts of old, they have now made their way online with even higher returns. That being said, they still can’t shake the core of their nature, which is locking in your funds for a pre-determined amount of time. To get the same rates as online high-yield savings accounts you would need to relinquish access to your funds for 9 months to 1 year. Since you can’t plan an emergency around your investing schedule, this is the biggest red flag that knocks CDs out of contention.
- Risk: These accounts are insured by the FDIC up to $250,000.
- Access: The higher-yield accounts are usually online only, but whether you set them up online or at the local branch, access before maturity is a one-way street if you don’t want a severe penalty.
- Fees: There are no fees going into CDs, but the real issue is that the penalties to access your funds prior to maturity negate all interest gains and then some.
- Transfers: CDs are a pain when you are just starting out because they are for a fixed amount of money for a fixed amount of time (e.g., 5K for 9 months). If you plan on contributing monthly, you have to set up a new CD every month. This is known as “laddering” and is double trouble when trying to use it as a emergency account. First you have to keep track of 12 CDs (one for every month) and then you only have 1/12 of your funds close to maturity.
- Returns: Better than a regular bank account and can surpass online high-yield savings accounts if you are willing to submit to long lock-in periods.
Money Market Deposit Accounts
A money market account (MMA) or money market deposit account (MMDA) is like a savings account, but instead of the financial institution determining the interest rate, the interest is based on current interest rates in the money markets. You can learn more about what is traded on the money markets on Wikipedia, but at the end of the day, there is very little difference between an MMDA and a high-yield savings account account except for there being more restrictions on an MMA account in return for (slightly) higher yields.
- Risk: These accounts are insured by the FDIC up to $250,000.
- Access: The higher-yield accounts are usually online only, but whether you set them up online or at the local branch, access to funds can happen in 24 -48 hours.
- Fees: There are typically no fees for MMDA accounts if you stay above their minimum balance, but if you need everything in your account to deal with a major emergency, expect some fees.
- Transfers: Automatic recurring transfers from a checking account to a savings account are usually standard with the institutions that offer these accounts
- Returns: Better than a regular bank account and can surpass online high-yield savings accounts if you meet the minimum requirements, but their rates are always in flux.
Money Market Fund Accounts
A money market fund (also known as a money market mutual fund) is an open-ended mutual fund that invests in short-term debt securities. Unlike MMDAs, money market fund accounts are NOT FDIC-insured and are treated like any other securities product whose return can be negative and can also reduce the principle to 0! These accounts are managed through securities brokerages such as Fidelity. They have their place in an overall investment strategy, but there is no room at the table for them when it comes to an emergency savings account, regardless of their prospective returns.
- Risk: While considered low risk by the investment community, the risk level is unacceptable in the context of emergency accounts.
- Access: Funds are accessible through a brokerage account at any time, but they can take a day or two to sell and transfer to your checking account.
- Fees: Expect typical brokerage fees.
- Transfers: Automatic recurring transfers from a checking account to a savings account are usually standard with the institutions that offer these accounts.
- Returns: There are no guarantees here and the principle you invested (not saved) is also at risk.
A high-level comparison of the financial products above allows us to quickly focus on the only two financial products that pass muster on the “must haves” in an emergency account.
|Standard Savings||High Yield Savings||Certificate of Deposit||Money Market Deposit||Money Market Fund|
Yield to Simplicity or Maximize Return
Now the question comes down to Simplicity vs. Return. First, to put returns into perspective, I have created a chart to illustrate the expected returns of an emergency account with $10,000 over a 10-year period.
Clearly, the high-yield accounts from ING Direct (now CapitalOne 360) and American Express outperform a traditional savings account from Citibank.
So, you might ask, why even consider the lower-yield account?
If you are just getting started on your financial journey, and dealing with a significant amount of debt, I would recommend you start off by simply setting up an emergency account at your primary bank. Since you are just getting your financial bearings with money management, having everything in one place gives you an extra sense of control on your finances. Moreover, while you are getting out of debt, your emergency account will only be about 1 month’s expenses or less, which reduces the difference between high yield and standard savings returns to microscopic levels.
Once you are debt free, and on the path to building a 6 – 12 month emergency fund which can equate to tens of thousands of dollars, making the switch to a high-yield savings account can offer at least a measurable return. This is precisely the path I took while in debt and continued on once I was free of it.