Simply having an emergency fund is what's most important, but you also need to know where to put it.
If you've made it a goal to build up your emergency fund in 2021, you're not alone. Because of the COVID-19 pandemic, many people are using this year to either replenish depleted emergency funds or add more money for a bigger financial cushion.
Since this is money for emergencies, where you keep it is crucial. It needs to be easily accessible at any time. It's also nice if you can earn some interest on your emergency fund money, but you don't want to put it anywhere the value could drop.
Keep reading for the types of accounts where you can store your 2021 emergency fund, starting with the top choice.
The best option: A high-yield savings account
High-yield savings accounts are perfect for emergency funds. They have some of the highest interest rates you can find without restrictions on when you can access your money or the possibility of losing any of it.
When you have a high-yield savings account, you can withdraw and deposit money at any time. Many of these accounts also have no monthly fees or minimum balance requirements. If you're just getting your emergency fund started, you won't need to worry about not having enough to deposit.
For the typical consumer, the best place for an emergency fund is a savings account. This is the type of account I use for my emergency fund and that I recommend to anyone who asks. Next, let's go over a few alternatives.
Money market accounts
Money market accounts aren't nearly as widely used as checking and savings accounts, but they have benefits of both. Their interest rates are often on par with those of high-yield savings accounts. Plus, you can access your money at any time, and -- like checking accounts -- money market accounts offer debit cards, checks, or both.
While a money market account can be a good place for an emergency fund, some have minimum balance requirements you must meet to either avoid a monthly fee or earn a higher interest rate. It's better to avoid accounts with these types of minimum balance requirements for your emergency fund. Your balance may dip below that minimum if you need to use some or all of the money.
Certificates of deposit
With certificates of deposit (CDs), you deposit your money for a fixed amount of time. Terms typically range from six months to five years. CDs tend to have higher interest rates than savings accounts do, so you can earn a little more of a return on your money. You also lock in the interest rate when you get the CD. That's advantageous if interest rates drop, but not if they go up.
The problem with using CDs for an emergency fund is that they have early withdrawal penalties. Take your money out before the end of the term, and it will likely cost you several months' worth of interest. You also can't add more money to a CD after you open it.
A CD isn't a bad place for your emergency fund, assuming you're willing to incur an early withdrawal penalty if necessary. But savings accounts and money market accounts are both much more flexible options.
What to avoid: Investment accounts
You may be tempted to invest your emergency fund. On average, the stock market offers a much greater yearly return than savings accounts, money market accounts, and CDs do. With any of the top online stock brokers, you could easily get a diverse portfolio by investing in index or mutual funds.
But the potential profit comes with greater risk, and that's why investing is one of the most common emergency fund mistakes. Although the stock market offers high yearly returns on average, there are also bear markets where values drop. And these periods often coincide with economic downturns, which is when you may need your emergency fund the most.
When it comes to your emergency fund, the smartest option is to keep it simple. A high-yield savings account will get you the most flexibility and a reasonable interest rate. Money market accounts also work well, and some consumers like to use CDs to earn more interest. Anywhere else, including investment accounts, isn't recommended.
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