Laddered Savings – For your emergency fund

Back a few posts ago we talked about where to keep your savings. CDs were mentioned as a good place to store funds that you don’t have an immediate need for yet that you can’t afford to take the risk of losing in the stock market. I am sure the minds of some of you out there jumped right to… “that sounds like a good place to store my emergency fund”.

And it is, with one catch: the length of time CDs tie up your cash. A 5 year CD – which normally has the best interest rate- is impractical. After all, an emergency fund is supposed to be there in case of emergencies. If your money is tied up for 5 years it won’t be available for emergencies.

Enter a concept called… laddering

Laddering, simply put, is a group of CDs –or bonds, but will talk about CDs- bought in such a way that they will mature at regular intervals.

Examples
Say you have $5,000 in your emergency fund. You could buy one CD for $5,000 that matures in one year… or five years. Or, you can buy 5 CDs of $1,000 each that mature in one, two, three, four, and five years, respectively. That is laddering.

Once the first year is up, if you don’t need the money, you can buy another 5 year CD. Now your 2 year CD matures in 1 year, the 3 year three in 2 years, etc. After five years you’ll have all your money earning good interest rates in 5 year CDs with out it all being tied up for five years.

Another option, instead of purchasing five year CDs, is to buy shorter term CDs. You could buy one 3 month CD. The next month buy another 3 month CD, and do the same the month after that. As they mature you can re-buy 3 month CDs and always have money maturing each month. This could also be done with 6 month CDs, or 1 year CDs.

Monthly or yearly maturities?
These two examples provide a good return while having your money mature at monthly, or yearly, intervals. How do you make this work in your emergency fund? Yearly maturities are too long to wait if an emergency comes up. Yet shorter term CDs provide less interest.

Ideally having 60 five year CDs, one maturing every month for five years, each being reinvested into other 5 year CDs as they mature, would be the way to go. You would get the best interest rates while having consistent access to money. Of course, the value of if each CD is an important issue. Having 60 $100 CDs is no good if you have an emergency requiring $500. To be effective though each CD would need to be enough to cover at least a months worth of expenses. But most of us do not have 60 months worth of expenses saved up. Though building up to five years of expenses would provide a very good rainy day fund.

Putting it together
Start small. If you have 3 months of expenses saved up consider laddering 3 month CDs so that one month’s expenses mature each month. 6 months of savings, consider a 6 month ladder. For those that have a years worth of expenses saved up, ladder CDs so that one matures every month of the year. That way you will always have access to one month’s worth of expenses if necessary.

Once your emergency fund contains over a year’s expenses, it is time to branch out. Keep at least one year’s expenses in CDs that will mature –providing one month’s expenses if necessary. The rest can then be used to ladder at higher interest rates in CDs that mature yearly. Work your way up to having 5 five year CDs each holding a year’s expenses.

If you keep this cycle going you will have a huge emergency fund, pulling in a decent interest rate, that will always be there when you need it.