Should You Invest Your Emergency Cash Stash?

PROMO: Keeping money on hand for emergencies is smart, but low rates are a drag.

By Dan Caplinger

Financial emergencies always seem to strike at the worst possible time. Keeping a stash of ready cash to help you weather financial storms can make it a lot easier to get out of a money bind without having to resort to payday loans and other costly lenders of last resort.

It can take quite a while to get there if you follow the advice of many financial experts and aim to set aside an emergency fund that's big enough to pay three to six months' worth of living expenses. With bank savings accounts paying just fractions of a percent in interest, the question many people ask is whether it makes more sense to invest your rainy-day fund in something that will provide a higher return.

The Cash Stash Dilemma

The major problem that most households have in setting up an emergency fund is in finding spare money to save in the first place. But even once you get past that hurdle, another issue comes from the fact that most people have little if any money in their long-term investment portfolios.

With so many competing demands on your money -- everything from everyday expenses to long-range goals like buying a house or paying for your kids' college education -- keeping thousands of dollars in an insured bank account that doesn't pay any significant return on your money represents a major waste of financial resources.

Simply speaking, you need your money to do double duty for your finances. But can you achieve the goals of having an emergency cash stash while scoring better returns from more promising investments?

Beating Low Returns

To answer that question, you have to take a close look at the reason you have your rainy-day fund in the first place.

In general, there are two different types of financial emergencies that come up, and the choices you have about what to do with the money you set aside for each type of emergency are different.

Unexpected expenses: On one hand, truly unexpected expenses demand quick attention. When your furnace or air conditioner breaks, putting off repairs for months usually isn't an option. When your car racks up hundreds of dollars in mechanics' bills, most people can't afford the disruption that not having a vehicle has on their daily lives, including getting to work.

Having enough spare cash to handle those types of emergency is extremely valuable. Although having a credit card whose balance you pay off every month can buy you a few weeks of extra time to gather funds, in general, you want that portion of your rainy-day money instantly available to get things taken care of immediately.

"What ifs" with warning: If you're fortunate enough to be able to have a larger contingency fund to handle things like job loss, temporary layoffs, or unexpected injuries that take away your income, then keeping an entire three to six months' worth of expenses in a savings account isn't as necessary. Typically, you'll have at least some warning that trouble at work may be coming, giving you some lead time to move money around if you need your entire emergency fund.

With whatever portion of your cash stash you don't need immediate access to, investments that provide higher returns can boost your income. Bonds and bank CDs can offer higher interest rates than savings accounts, although their rates are also fairly depressed. Many dividend-paying stocks provide higher amounts of income than you can get from most income-paying alternatives. Of course, with stocks, a market downturn can cause substantial losses, and even with bonds and bank CDs, you can lose money or have to pay penalties if you end up needing to sell them off in an emergency situation.

Make Your Money Work Harder

In order to have your emergency cash stash truly available for emergencies, you'll want to make sure you keep at least some of your money in a safe place like a savings account, despite their low interest rates. But as you get closer to your eventual goal, trying to let your emergency fund do double duty makes more sense.

You can follow Motley Fool contributor Dan Caplinger on Twitter @DanCaplinger.

You can follow Motley Fool contributor Dan Caplinger on Twitter @DanCaplinger.