How crazy is this EF idea?

[kork13]

I've been thinking about this for a while, and decided it's worth getting everyone's opinions on... I know that liquidity is always considered paramount with an EF, but I'm wondering how "liquid" it truly needs to be. My EF is currently earning 2% interest, and my goal is $15k (6 months' expenses). I'm at ~$10k right now, and expect to have it finished off by the end of the summer.

Once I get it to that $15k, I'm considering putting it into the highest-rate (longest-term) CD that I can find. Right now, that would be about 4% for a 7yr CD. If for some reason I needed it (low probability...see below), it would take no more than 3-4 days (max) to get it out of the CD. I would sacrifice 3 months' of interest (~$150), but that would be more than made up for when you consider that I'm making double the interest I'm currently making. After the first 6 months, all interest I get would be above and beyond what I'd otherwise be getting, even accounting for the early-withdrawal penalty. In the future, if/when rates rise, I could figure out an appropriate "break even" point, close the 4% CD and re-open a new long-term CD at the higher rate. This all seems like a way to have the safety of an EF while still earning a decent rate of return on it.

Mitigating circumstances...
- I'm in the military, so my job/income are pretty secure. Medical expenses are covered for me.
- I don't own a home, so any maintenance required on my house is not my expense.
- I own (outright) a 3y/o, reliable car (Honda Civic), and it's fully insured.
- I've always lived on no more than 70% of my income, and can stop my savings contributions at any time if necessary.
- I keep about a month's expenses in my checking account as a buffer ("just in case"), and also have easily accessible money elsewhere.

So two questions come out of all this: Is this a crazy/stupid/bad idea? What am I missing?

[jIM_Ohio]

Its a decent idea with SOME of the money.
The question to ask- is what emergencies might exist where you need to access ALL 15k immediately?

Why not 7 different 2k CDs, each CD maturing 1 year from the other? gives you access to 2k quickly, and its possible your penalty will be lower on 2k than on 15k.

[swanson719]

EF's are for emergencies, not interest. That being said, you always want them in the highest interest place you can find that's not going to put you at risk. It sounds as if you've thought this through. The one thing I would ask yourself is what's the most catastrophic thing that could happen in your situation. And then, do you have enough in checking or simple savings to deal with that for 2 or 3 days while you wait for the CD to be released? You have enough in checking for emergency leave and a car insurance deductible it sounds. I'm still a bit uneasy about the 7 year CD concept in general, but if you really can pull it out with as few penalties as you say, then I don't see the problem.

[Broken Arrow]

You sure I can't interest you a high yield checking account instead?

4.09% APY for up to $25k.

There are some qualifications of course, such as making 12 check card purchases per month, setting up direct deposit and billpay, and whatever other requirements that are listed in the link.

But once set up, the money is completely liquid. Use your check card if it's urgent. Write a check if you want a paper trail. Electronically transfer your funds if you don't mind waiting a day or two.

Just a thought.

[disneysteve]

I agree with Jim. You don't want your whole EF in one CD. You wouldn't want to have to cash out a 15K CD to pay an unexpected 2K repair bill. You also don't want to lock in a rate that looks good today only to have interest rates climb over the next year or two and make that rate look not so good anymore. Build a ladder of CDs instead.

[kork13]

I really appreciate the comments already, they're all excellent.

Originally Posted by jIM_Ohio

Why not 7 different 2k CDs, each CD maturing 1 year from the other? gives you access to 2k quickly, and its possible your penalty will be lower on 2k than on 15k.

That makes alot of sense, I like that idea alot... I don't think it's realistic in this particular case to do a true ladder -- it would take me 7 years to set it up, or require 7 CD's of different terms/lower rates, which sort of defeats the objective. However, to gain a similar effect, perhaps I could do it in 8 $2000 CDs, just separating them by 1-2 months. It would still take a while to set up, but not so long. That way I would have the option of how much to tap at a time. Plus, that makes it alot easier to add additional CDs later on if/when I need to expand my EF.

Originally Posted by disneysteve

You also don't want to lock in a rate that looks good today only to have interest rates climb over the next year or two and make that rate look not so good anymore.

Noted. I'm thinking that it would only be beneficial to close/re-open (essentially reset) the CDs in order to gain at least an additional 1%, with a break-even point at about 1 year. Definitely a significant consideration.

Originally Posted by swanson719

I'm still a bit uneasy about the 7 year CD concept in general

Trust me, I feel the same way. I'm only even considering this as an option purely from a numbers perspective... I've not totally sold myself on the idea yet, and I'll probably continue to refine the plan over the next few months... If I go through with it at all. Right now, I don't know.

Originally Posted by Broken Arrow

You sure I can't interest you a high yield checking account instead? ... There are some qualifications of course, such as making 12 check card purchases per month, setting up direct deposit and billpay, and whatever other requirements that are listed in the link.

I have considered a high-interest checking account, but I really don't want to add another bank to my list, and as I mentioned earlier, I'm not overly concerned with the "non-liquidity" that this setup presents. I've currently got accounts with 5 banks, which I pared down from 6 at the New Year. This idea would have all of the CD's with my primary bank (USAA) which I love working with anyway, and would enable me to eliminate another bank. Part of this idea's advantage is also that it simplifies things for me.

[Beppington]

Originally Posted by kork13

I have considered a high-interest checking account, but I really don't want to add another bank to my list, and as I mentioned earlier, I'm not overly concerned with the "non-liquidity" that this setup presents. I've currently got accounts with 5 banks, which I pared down from 6 at the New Year. This idea would have all of the CD's with my primary bank (USAA) which I love working with anyway, and would enable me to eliminate another bank. Part of this idea's advantage is also that it simplifies things for me.

This brings up a question I have: Anything wrong with having accounts at manh banks?

[disneysteve]

Originally Posted by Broken Arrow

You sure I can't interest you a high yield checking account instead?

4.09% APY for up to $25k.

Keep in mind that with this option, the interest rate could change at any time. With the CD, the rate is fixed for the term of the certificate.

[jIM_Ohio]

Originally Posted by kork13

I really appreciate the comments already, they're all excellent.

That makes alot of sense, I like that idea alot... I don't think it's realistic in this particular case to do a true ladder -- it would take me 7 years to set it up, or require 7 CD's of different terms/lower rates, which sort of defeats the objective. However, to gain a similar effect, perhaps I could do it in 8 $2000 CDs, just separating them by 1-2 months. It would still take a while to set up, but not so long. That way I would have the option of how much to tap at a time. Plus, that makes it alot easier to add additional CDs later on if/when I need to expand my EF.

Noted. I'm thinking that it would only be beneficial to close/re-open (essentially reset) the CDs in order to gain at least an additional 1%, with a break-even point at about 1 year. Definitely a significant consideration.

Try this for a CD ladder:

Open 1 7 yr CD with 2k at 7% interest
open 6 other 2k CDs, maturing at 1-2-3-4-5-6 year intervals

when each CD matures, roll it into a new 7 year CD.

If you put all 15k into a single CD, you have too much interest rate risk. 7% looks good now, but in 4 years, what will it look like?

OR

open 7 different 2k 7 year CDs now- so if you have a 2k emergency, you don't pay a 15k interest penalty on the whole CD when you only needed 1/7 of the money.

[jIM_Ohio]

Trust me, I feel the same way. I'm only even considering this as an option purely from a numbers perspective... I've not totally sold myself on the idea yet, and I'll probably continue to refine the plan over the next few months... If I go through with it at all. Right now, I don't know.

What you want to explore is a "primary-secondary" EF route I think. You like seeing the 7% numbers, but might be exploring the penalties to gain access to the money in these situations.

Try this:

15k, 7% return per year is $1050 per year.

If you did the following:

open 12 $1000 1 year CDs, in a ladder, what would they earn? maybe 1.5%. meaning its yearly return is $180.

With other $3000, choose an investment which has "more risk" than a CD and attempts to make up the other $900 in returns you lost. Look at a mutual fund which is 100% bonds, or possibly 20% stocks and 80% bonds.

If the $3000 earns 25%, you made up for most of the missed $900 in returns. We both know that the likelihood of this happening (25% returns) is low...

so do some math

$3000 earning 7% per year and $12,000 earning 1.5% per year
put all interest into the $3000 portion (so add $180 to it per year).

Maybe its a different split (not 12k/ 3k, but maybe 6k/6k)
My point is that instead of putting 15k in one single position (CD or other) divide it up, putting a small portion of the 15k into something which has a chance for higher return.

[kork13]

**face-palm**

Okay, so as I said, I haven't totally gone into the details of this plan. This morning I did look at some of the details, and it dramatically changes the situation. I made the (faulty) assumption that the 3-month penalty that I've seen on most CD's I've had/looked at was standard regardless of term. Looking through the terms/conditions of both banks I would consider using, I've discovered I was drastically mistaken. The penalties I found were this: Terms 1yr and below: 3 months. Terms above 1yr and below 7yr: 6 months. Terms 7yr and above: 1 year. It just happens that I've never seriously looked into a CD above 1yr in term! hahaha oops...

So after laughing at myself a bit, I re-thought my little idea here... I could get a bunch of $1000 5yr CD's @ 3.5%, separated by 1 month each. The break-even point (compared to my current 2% rate, including the penalty) would be about 12 months. From there, the break-even for a 1% raise in rate (assuming I reset my CD's) would be about 18 months. This new realization makes it less of a compelling argument, but still not out of the question.... I think to do this, I would have to keep basically a mini-EF (maybe $5k) in something more liquid, and just accept the lower rate. This scenario would allow me enough ready cash to avert most 'emergencies' without tapping the CD's, but it would still be acceptable if the need arose to cash out some of the CD's.

hmmmmm...... considerations abound....

[jIM_Ohio]

Originally Posted by kork13

**face-palm**

Okay, so as I said, I haven't totally gone into the details of this plan. This morning I did look at some of the details, and it dramatically changes the situation. I made the (faulty) assumption that the 3-month penalty that I've seen on most CD's I've had/looked at was standard regardless of term. Looking through the terms/conditions of both banks I would consider using, I've discovered I was drastically mistaken. The penalties I found were this: Terms 1yr and below: 3 months. Terms above 1yr and below 7yr: 6 months. Terms 7yr and above: 1 year. It just happens that I've never seriously looked into a CD above 1yr in term! hahaha oops...

So after laughing at myself a bit, I re-thought my little idea here... I could get a bunch of $1000 5yr CD's @ 3.5%, separated by 1 month each. The break-even point (compared to my current 2% rate, including the penalty) would be about 12 months. From there, the break-even for a 1% raise in rate (assuming I reset my CD's) would be about 18 months. This new realization makes it less of a compelling argument, but still not out of the question.... I think to do this, I would have to keep basically a mini-EF (maybe $5k) in something more liquid, and just accept the lower rate. This scenario would allow me enough ready cash to avert most 'emergencies' without tapping the CD's, but it would still be acceptable if the need arose to cash out some of the CD's.

hmmmmm...... considerations abound....

Ideas like this are what forums are good for... you have an idea, and it turned out to be "wrong", but off that one bad idea you might have a good one.

a 12 month ladder of CDs... is each CD 1 months expenses?

if each CD is not one months expenses, I will suggest you rethink the size of the EF or the duration of the CD.

Your problem (as you presented it) is that you are looking at return first (7% then 3.5%) and then also chasing liquidity vs penalty fees and similar.

If you "change the problem", you might find other solutions.

For example, what is amount of money you WANT in your EF? 3 months expenses, 6 months expenses, 12 months etc...

then in same example, what is likelihood you need a given amount of money? and why? job loss, house repair, car repair, hurricane, vacation etc...

If you spend $3500 in a given month (assuming that based on 1st post), and you have 15k to invest... look at slice and dice for portions of the money. My best guess is you will not need 15k all at once (paying ransom money?), and even needing 3.5k is about your "worst case" scenario.

Situation A
So put 3.5k in 90 day CDs (3 CDs each 30 days apart)
then chase return with the balance with cash based investments (treasury direct.gov is a good place to see returns for cash)

Situation B
put 3.5k in 180 day CDs (6 CDs each 30 days apart)
then go for higher return than situation A (long term CDs and bond funds)

Situation C
put 3.5k in 12 month CDs (12 CDs 30 days apart)
then go for higher returns than situation B (some equity exposure such as RPSIX or PRPFX.

As you keep more cash, you can take more risk with incremental amounts of money because you have low liquidity risk and higher inflation risk.

If 15k represents 3 months expenses, you are wise to pay attention to the penalties and focus less on return... because you are dealing with less money than if 15k represents 6 or 12 months expenses. Make sense?

[kork13]

Originally Posted by jIM_Ohio

Ideas like this are what forums are good for... you have an idea, and it turned out to be "wrong", but off that one bad idea you might have a good one.

Definitely, and I'm VERY grateful for having you all to bounce my (occasionally radical) ideas off of.

Originally Posted by jIM_Ohio

a 12 month ladder of CDs... is each CD 1 months expenses? if each CD is not one months expenses, I will suggest you rethink the size of the EF or the duration of the CD.

My idea hasn't really been to build a CD ladder. I'm leaning more toward having a series of small but long-term CD's for flexibility and return -- a bunch of $1k CD's, even though a full month's expenses is actually more like $2500.

Originally Posted by jIM_Ohio

Your problem (as you presented it) is that you are looking at return first (7% then 3.5%) and then also chasing liquidity vs penalty fees and similar.

I think you misunderstood the initial post... I first brought up 7yr CDs at 4%. Next it was 5yr CDs at 3.5%.

Originally Posted by jIM_Ohio

Situation A
So put 3.5k in 90 day CDs (3 CDs each 30 days apart) then chase return with the balance with cash based investments (treasury direct.gov is a good place to see returns for cash)

I totally forgot about treasurydirect.gov... I already buy I-Bonds as part of my savings for eventually buying a house. That actually might be the best option for me, because I-Bonds do only charge a 3-month interest penalty, and the rate is still pretty decent (3.365% right now, historically averaging ~4%)

So yet another revision to the plan...

Part 1: Keep $5000 in a totally liquid savings account. This should be enough to cover most any emergency.
Part 2: Over time, buy a series of 10 $1000 I-Bonds. If it became necessary, these could be cashed in for a lower penalty than CD's (and zero penalty after 5 years), and I have the freedom to cash in only what I need.

Negative considerations:
- It's impossible to withdraw within the first year.
- I can only buy $5000/yr, and I'm already buying $3000/yr for my house-fund. So it's gonna take some time....

That obviously doesn't bring as high of a return as the other options, but of the three iterations this idea has had so far, I think I'm most comfortable with this one, except for the fact that it's gonna take quite a while to set it up.

[disneysteve]

Originally Posted by kork13

That obviously doesn't bring as high of a return as the other options

But remember that the CD rate is fixed for the term. The I-bond rate adjusts every 6 months. If inflation rises, as it has to since it is sitting at zero right now, the bonds become more valuable. Also, the I-bonds have tax advantages over the CDs.

To deal with the fact that you can't redeem an I-bond in the first year, you could put some money in CDs and some in I-bonds so that you can access funds if needed. Once the first year is up on the initial I-bonds, you can move the rest of the money into them.

[snafu]

I must be thick! Given your the personal outline that opened this discussion, I can't imagine why you strive for a 15K EF. Has anything in your past experience given you cause to anticipate a $15K Emergency? The flex you have in your day-to-day banking would cover nearly any problem. If pressed, put what is needed on a CC and pay the bill when due using their 21 day float.

If you must make an emergency flight, would you not use a CC for efficiency? If your car needed an expensive repair would you not prefer CC for record keeping and their assistance if it's a scam. If your home burned down, CC would be more secure for insurance reimbursement I reckon. It takes 3 days to get funds transferred from any mutual fund or money market to checking.

You are young enough to absorb risk [that four lettered word]. I suggest, had you DCA/ed into an Index fund, you would have exceeded your target over the past 15 months!

I keep a float of $1K in checking to fend off bank charges and run sums through what used to be high yield savings as I sweep end of month sums to various investment tracks to help DH understand the plan more easily. In my view, a laddered CD would be more appropriate for seniors who can't replace losses, those whose employment is rocky and those who fear medical emergencies which are foreign in my experience/country.

[disneysteve]

Originally Posted by kork13

Mitigating circumstances...
- I'm in the military, so my job/income are pretty secure. Medical expenses are covered for me.
- I don't own a home, so any maintenance required on my house is not my expense.
- I own (outright) a 3y/o, reliable car (Honda Civic), and it's fully insured.

Originally Posted by snafu

I must be thick! Given your the personal outline that opened this discussion, I can't imagine why you strive for a 15K EF.

snafu makes a really good point. Your income is secure. You have no debt, no medical expenses. You have no housing expenses. You have a new car so you've got some maintenance costs there. What could possibly happen that would cost you 15K and that you would need that money quickly?

[kork13]

Originally Posted by snafu

I must be thick! Given your the personal outline that opened this discussion, I can't imagine why you strive for a 15K EF. Has anything in your past experience given you cause to anticipate a $15K Emergency? The flex you have in your day-to-day banking would cover nearly any problem. If pressed, put what is needed on a CC and pay the bill when due using their 21 day float.

A valid point, and a question that I have put to the fire many times. As you bring up, I do put everything on my CC, and normally pay it off before the statement even posts online, so I would have that float as a backstop if necessary. However, I'm just not comfortable having ZERO in a readily-accessible account, because I have had months in the past where I've spent more than expected, and had to dip into my liquid savings a bit. Also, it's just a matter of prudence. Yes, I probably COULD be okay with just keeping $3k-$4k in a savings account and have that be it, but I strongly believe in the "just in case" mentality. I often hear a 3mo EF recommended for people in the military, but again, "just in case".

As for my expected emergencies.... Within the next 3-4 months, I'll be moving overseas to Japan, where nearly everything is more expensive, and I'm planning for my expenses to increase by $1k-$2k, though I'll also receive $3k more in monthly gross pay, between COLA pay and an upcoming promotion in June. My biggest anticipated cost would be either some major breakdown with my car (I'm not allowed to bring my current car with me, so I'll have to get a different one out there), or needing to take emergency leave for family illness/death (I unfortunately do have some family history with this...), both of which could cost $2k-$3k in a single fell swoop (airline tickets can easily be as high as $1500).

All of that said, I am open to criticism -- Given my situation, am I really being over-cautious? I'm aiming for a $15k EF (6mo), but would my current $10k (4mo) be more realistic? Or should it be even less than that?

Originally Posted by disneysteve

You have no debt

To be completely accurate, I do actually have ~$20k in a "career-starter" loan I got in college, but it's at only 1% interest, and I count those debt payments ($520/mo) as a part of my monthly expenses.

[disneysteve]

Personally, I'm of the opinion that most of our financial assets are available for emergencies if necessary. The only things that I don't count are IRA/Roths, 401k and 529 money. I consider all of that untouchable. Everything else - checking, money market, stocks, bonds, mutual funds, etc. are all available if something bad were to happen. Some money needs to be liquid but it doesn't all need to be liquid.

In your case, I'd see nothing wrong with keeping perhaps 5K liquid, another 5K semi-liquid and invest the rest.

[jIM_Ohio]

All of that said, I am open to criticism -- Given my situation, am I really being over-cautious? I'm aiming for a $15k EF (6mo), but would my current $10k (4mo) be more realistic? Or should it be even less than that?

Only you can decide what is "too cautious". Don't let us tell you how much risk to take... what I try to do is suggest if this, then this. if this, then this. You know your situation better than any of us ever will and you care more than we do- its your money.

Look at a layered EF approach

layer 1, high liquidity. Short term CDs or savings accounts or money markets. Focus on liquidity here, not return. Think 3 month CD ladder.

layer 2. medium liquidity, better return. Medium liquidity might mean a fee to access money or a delay in 2-3 days to access money.

layer 3 stability of principal focus, with return which beats inflation being important. Access to money would be measured in months or years (wait for right time to sell).

If layer 1 is a 3 month CD ladder, layer 2 could be a longer ladder (2-3 year CDs).
If layer 1 is a 6 month CD ladder, layer 2 could be a moderate risk mutual fund which invests in bonds or stocks (30% stocks is as high as I would go, but have read about people using Wellesley for this which is 40% stocks).
If layer 1 is a 3 or 6 month CD ladder, its possible the government bonds are an option, but as other posts have pointed out, this takes "time" to set up because bond maturities have less granularity, you might need to wait for an auction, and there are sales restrictions depending on the type of bond.

Some common planning examples I look for:

1) self employed person- want 6 months layer 1, 18 more months in layers 2 and 3. Logic- if person becomes disabled short term, money is needed. My cousin works for his father in law as a plumber. He broke is leg in November, and just returned to work in January. Only way he gets paid is if he works.

2) sales person or variable income- put 3 months in layer 1, with 9 months layer 2, and another 12 months in layer 3. Logic- The person might need money because of a bad year, so keeping access to 12 months in cash is important, however most of the time people in fields like this make more money than the rest of us, so directing as much excess to layer 3 when times are good is important.

3) stable employment, conservative finances
3 months layer 1- keep it in cash
enough in layer 2 to justify risk taken for layer 3 (this greatly depends on person's risk tolerance.
For example I can justify to myself that I need 3 months in layer 1, 0 months in layer 2 and as much in layer 3 as we can afford to send there. My logic is that if an emergency happens, I can stop layer 3 contributions and the monthly contribution might cover the emergency.

I have layers 1 and 3 right now... but do not contribute to layer 3 anymore, so when I need money, I turn off IRAs for a month or two, and leave the EF untouched.

[kork13]

hmmm... Alot to think about. I initially asked this question just to see if I was nuts to even consider it. But in the meantime, I think I've learned alot about what I actually do and don't want/need to do... For one, I realized that I kinda applied a broad-stroke approach without really considering my personal situation. So thanks everybody.

I think I've figured out what I'll be doing with my EF from here out, at least for the foreseeable future... I like the idea of 'layers' with varying levels of liquidity that Jim and DS bring up, and I think I'll move toward something of that form. Thanks again.