Emergency savings in a bank?

Q - I've been able to save up about $12,000 in emergency savings. But it's just sitting in the bank earning little interest. Is there a better option?

A - Yes. As you accumulate emergency savings, a better approach is to put it into two or three accounts to accomplish three things: quick access, earn enough interest to avoid losing out due to inflation, and maintain a relatively stable value. Let's go over these characteristics. For quick access, consider that not all emergencies are immediate. A water heater is immediate, while capping a cracked tooth isn't. The amount of money needed immediately out of emergency savings is determined by your access to credit. If you have a credit card with a $5,000 credit line and no balance, then that provides payment for your immediate emergency until you pay the bill with funds from an emergency savings account. If you don't already have access to credit, then more money needs to stay in the bank.

For less immediate needs, emergency savings can be deposited into an account at a financial services provider (e.g., Fidelity, Charles Schwab, Vanguard) that offers money market funds, as well as a variety of short-term bond funds. Currently, money market funds are paying ~4.0%, while some short-term bond funds are offering rates of up to 4.5%. Therefore, $10,000 could return $400 a year in interest. With these accounts, money can be transferred to your bank account within a few days. The electronic connection also allows for easy deposits, so you can continue to grow your balance. Once above half of what you estimate your emergency funds should be, you can diversify into other funds that offer higher returns but are still relatively stable. By relatively stable, I mean a very low chance of dropping 10% due to a financial crisis. Many short-term and intermediate-term bond funds would meet that criteria, but I favor the "Floating Rate" funds due to their 6%+ yield and short duration, meaning the value won't drop too much if interest rates rise.

Also, as your emergency fund balance grows, you can consider other funds that offer greater interest or dividends, but may be more difficult to access. By this, I mean funds that impose frequent trading limitations, such as only allowing one withdrawal per month, for example. This portion of emergency funds is meant for more long-term emergencies, such as a job loss. Thus, by the time you get to a fully funded emergency fund, for example, $20,000, except for $1,000 to $5,000 kept in the bank for immediate needs, the rest is invested for larger returns, with a portion available within days. As your balance increases, it can grow itself with higher returns, requiring less and less to be added on a regular basis.