Four reasons for 5-year CD's in your Emergency Fund

Since the new normal set in a few years back, I've recommended you build reserves you can tap in the event of a real financial emergency. You should store your Emergency Fund in a safe place, like a credit union or a bank and keep it separate from checking and other accounts. Here are four reasons why I like five year certificates of deposit for the physician family's Emergency Fund:

  1. Five-year CD's beat the rates available on demand deposits, like checking and money market accounts. A quick peek of the top rates via BankRate.com  shows that today's top-yielding 5-year CD's have an annual percentage yield  (APY) of 1.99% while money markets with a $25K deposit yield 1.00% APY and checking yields a paltry 0.25% APY.
  2. The sting of the early withdrawal penalty is a good thing. The typical 5-year CD imposes a penalty equal to six months worth of interest, so the thought of "paying a penalty" is probably enough to help you use the fund only for emergencies.
  3. Don't let the penalty take your eyes off the prize They're still better than 1-year CD's for most doctors. For example, let's assume you hold $100K in a one-year CD versus that same amount in a five-year CD. And let's assume you have an honest-to-goodness emergency that wipes out the whole pile after only 12 months. With the best one-year CD available today, you'd earn about 1.15%. With the five-year CD, you'd earn 1.99% minus about 0.99% for penalties, leaving you with about 1% in yield. Does it look like you're giving up 0.15%? Not so fast. The chances of actually having an emergency are small if you're doing your financial planning the right way.
  4. You stand a chance to make twice as much in five-year CD's as in one-year CD's. If you don't have an emergency and you keep your five-year CD, you'll earn 1.99% every year (plus compounding) for five years, versus only 1.00% for your one year CD (and maybe more or less depending on what interest rates do in the future). Both of these options easily beat checking accounts.

Before you buy a five-year certificate of deposit read the find print. Many five-year CD's bear a six month prepayment penalty but some have a twelve month prepayment penalty, and most will charge that penalty regardless of how long you hold the CD. That means if you cash out the CD in the first three months, you may be forced to pay a portion of your principal as well as all your interest.

Remember, these are long term, emergency only instruments that won't earn much, but they'll help you stop worrying about money and sleep well knowing you're prepared for a financial emergency.

Wanna know the difference between investing and saving? Submit a comment and I'll tell you. J