Invest in Your Emergency Fund – Instead of Your 401(k)

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While a stockpile of cash is unlikely to generate any top-notch returns, for many people, an emergency fund could have prevented the financial and retirement peril created by an on-going recession.  According to a recent Monster.com poll, more than 50% of Americans have less than one-month of income saved.  After one month, those polled would have to tap their retirement savings or other critical investments.

How Much Savings is Enough?

It is universally accepted that employees should seek to save as much as six months of income before investing in retirement funds and other long term plans.  With an emergency stockpile of cash, investors and workers alike would be able to weather any short term economic storm and have enough resources to make it through without irreversibly damaging their fiscal position.  Six months of saved income follows six months of unemployment benefits, which grants a full year of job searching, a length that appears ample for virtually every industry.

Risking Your Credit and Future Profession

The smallest of slip-ups in your payment history are black marks to the banking and lending industry.  Each late payment recorded is another reason for lenders to avoid you as a credit risk and employers to look over you as irresponsible.

A study by NPR found that 42% of all employers check credit scores, thus having a low score could prohibit you from securing a job at one of the few places that are hiring.  In addition, interest rates on debt and other obligations are likely to skyrocket after one missed payment, further inducing fiscal burden while left jobless.

In a recent example, Chase raised the minimum payment on thousands of late accounts to 5% of the minimum balance from 2%, an increase that sent many minimum payments from $200 and $300 per month to $500 and $750 per month.  For a person living on a budget, without weekly salary checks or any means of income, the explosion in costs only lowers the amount of time before bankruptcy.

Retirement Money Isn’t Free

Beyond the credit risks and possibility you may be out of a job for a long time, you must consider the cost to access what money you might have.  Early withdraw penalties in 401k programs total 10% of the balance withdrawn.  Using a model that suggests the Dow has produced average returns of 10% per year, you would be effectively giving up an entire year of growth on your account just to have the money that you put in 12 months ago.  Alternatively, with many retirement accounts still off their 2007 peaks, you would be forced to sell your assets at one of the least expensive points in history, and you would need to play catch up when stock prices soar higher.

How an Emergency Fund CAN Make You Money

Unfortunately, when it comes to investing, liquidity and safety are two words that often correspond with some of the least profitable investments.

However, consider this scenario to illustrate the importance of an emergency fund.  You earn $3,000 per month post-tax and have saved up $18,000.  One year after you started your job, you’ve lost it, but you have savings of $18,000 for the next six months.  If you had invested the money into a retirement account, such as a 401k, it would cost you $1800 to withdraw it.  By keeping the money in cash, you’ve saved that $1800, effectively earning yourself a 10% rate of return (plus bank interest) when comparing your situation to the 401k alternative.

How to Generate Maximum Returns with an Emergency Fund

Luckily for investors, rates are often the highest when an emergency fund is dormant and lower when your emergency fund may need to be utilized.  Generating maximum wealth from your emergency fund can be obtained by using a simple, but effective, tool that has been in use for decades in the bond industry.  In order to get the highest average returns, bond investors will often invest in a variety of maturity dates to spread out their wealth with their portfolios.  Likewise, the wise use of certificates of deposits can generate better returns, as well as provide liquidity.

The Six Month CD: A Recession Savior

Knowing that a health emergency fund consists of six months of saved income, we’ll use a six month CD as the example.

Should your emergency fund contain $18,000, you would want to slowly, month by month, take one month of earnings and place it into a six month CD.  After six months, you would have six CDs, with one just maturing and five more to mature in the following five months.  Although CDs are not known for their liquidity, there is a tremendous benefit in the CD rollover; each month, a new CD can be used or it can be again rolled over, obtaining the maximum amount of interest.

Currently, money market accounts yield little more than 1% per year; a six month CD, however, yields 1.3% per year.  Though the spread seems tiny now, as rates are down to historic lows, the spread during economically prosperous times often reaches 1-2% per year.  Should you be in a poor fiscal position, that same 1-2% may make all the difference in having enough money before the next job opportunity opens its door.

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