The Three Worst Places for Your Emergency Fund

Let’s face it: when an emergency hits, you need quick access to cash. But some options can do more harm than good. This isn’t about judging; life happens. We want to help you avoid unnecessary financial strain.

We’ll start with the least terrible of the bad options and work our way down to the absolute worst.

Third Worst: HELOC (Home Equity Line of Credit)

A HELOC, or Home Equity Line of Credit, is a line of credit secured by the equity in your home. Think of it as a second mortgage that you can draw on as needed. A similar product, a home equity loan, provides a fixed amount of money upfront. With a HELOC, you only borrow what you need, when you need it.

One advantage of a HELOC is that it typically offers lower interest rates than credit cards. Why? Because your home serves as collateral. The lender has something to seize if you fail to repay.

But that’s also the major risk. If you can’t keep up with the payments, you could lose your home.

There’s one specific scenario where using a HELOC might be acceptable: as a temporary backup while you’re actively building a proper emergency fund in a better location.

Imagine you have significant equity in your home but haven’t yet built up a cash cushion. A HELOC could provide a safety net while you prioritize saving.

However, this is not a common or ideal scenario. It’s far better to have a fully funded emergency fund before considering a HELOC.

Don’t be tempted to rely on a HELOC as your primary emergency fund. The risk to your home is simply too great.

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Warning: Using your home as collateral puts you at risk of foreclosure.

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Second Worst: 401(k) Hardship Withdrawals

A 401(k) hardship withdrawal involves taking money out of your retirement account when you have a significant and immediate financial need. Unlike a 401(k) loan, you don’t intend to pay the money back.

It’s understandable that people sometimes face situations where they feel they have no other choice. Life can be unpredictable, and emergencies can arise.

But taking a 401(k) hardship withdrawal comes with major drawbacks: taxes and penalties. You’ll not only reduce your retirement savings but also lose a significant portion of the withdrawal to the IRS.

A 401(k) loan is a slightly better alternative if you intend to repay it. You borrow from your own retirement savings and pay yourself back with interest.

However, 401(k) loans still carry risks. What if the market plummets after you take out the loan? You’ll be repaying the loan with after-tax dollars while missing out on potential market gains.

Most 401(k) plans have limitations on the amount you can borrow. Many plans cap loans at $50,000, according to Department of Labor regulations.

Your 401(k) should not be your primary emergency fund. It’s designed for long-term retirement savings, not short-term emergencies.

Imagine you take out a $10,000 loan, but the market surges while you’re paying it back. You miss out on those gains. Conversely, if the market crashes, you’re still obligated to repay the loan, even though your retirement account has lost value.

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Warning: Avoid 401(k) withdrawals if possible. The penalties and lost growth can severely impact your retirement savings.

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The Absolute Worst: Credit Cards

Let’s be crystal clear: credit cards should never be considered your emergency fund.

The primary reason is simple: high interest rates. Even if you have excellent credit, you’re likely paying interest rates in the high teens, perhaps close to 20%.

While some people are tempted to use credit cards for the rewards points, consider this: using a credit card for points is okay only if you can pay it off immediately.

Carrying a balance and accruing interest will quickly negate any rewards you earn.

Credit card debt can spiral out of control faster than you might think.

Imagine you put a $2,000 emergency expense on a credit card with a 20% interest rate. If you only make the minimum payment, it could take years to pay off the balance, and you’ll end up paying far more than the original $2,000.

Avoid credit card debt at all costs. It’s a financial trap that’s hard to escape.

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Warning: Credit card interest rates can quickly turn a manageable emergency into a long-term debt problem.

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From Worst to Best

We’ve covered the three worst places to keep your emergency fund: credit cards, 401(k) withdrawals, and HELOCs. All can create more problems than they solve.

Having an emergency fund is essential, but it needs to be in the right place. Let’s explore the best options for your rainy-day savings.

The Three Best Places for Your Emergency Fund

Now for the good news: there are several safe and accessible places to keep your emergency fund. These options prioritize safety and liquidity, ensuring your money is available when you need it.

Let’s work our way up to the absolute best.

Third Best: Taxable Account (Low-Risk Investments)

A taxable account is an individual or joint brokerage account where you can buy and sell investments.

The key requirement for using a taxable account as an emergency fund is to stick to low-risk investments.

Specific examples include money market funds and U.S. Treasuries.

Money market funds are a type of mutual fund that invests in very short-term, low-risk debt securities. U.S. Treasuries are bonds backed by the U.S. government, considered virtually risk-free.

While bonds are generally safe, they still carry some risk, especially interest rate risk and duration risk.

Interest rate risk refers to the possibility that bond prices will decline as interest rates rise. Duration risk measures a bond’s sensitivity to interest rate changes.

The bond market’s performance in 2022 serves as a reminder of these risks. Bond values decreased.

U.S. Treasuries are considered “risk-free” because they’re backed by the U.S. government. The government can always raise taxes to meet its obligations. The 10-year Treasury yield is often used as the “risk-free rate” in financial models.

A taxable account offers easy access to your funds. You can typically sell your investments and withdraw the cash within a few business days.

The taxable account is a great option, but not the best.

Second Best: Traditional Bank Account

Using a traditional bank account is the most common, but not the best.

A traditional bank account refers to a checking or savings account at a brick-and-mortar bank. These accounts offer easy accessibility. You can withdraw cash from an ATM or visit a local branch.

However, traditional bank accounts typically offer very low interest rates, often lower than the rate of inflation. Inflation erodes your purchasing power, which is the amount of goods or services you can buy with a certain amount of money.

Imagine a loaf of bread costs $3 today. If inflation is 3% per year, that same loaf of bread will cost $3.09 next year. Even though you still have the same amount of money, it buys less.

Even if you stash cash in a safe, that isn’t ideal. You won’t earn any interest, and your money will lose purchasing power over time. Also, if your house burns down, your homeowner’s insurance policy might only cover a small amount of cash.

While it’s “better than nothing,” it’s not optimal.

Consider that the average savings account interest rate at a traditional bank is around 0.06%. With inflation hovering around 3-4%, your money is losing value in real terms.

The Winner: High-Yield Savings Account (Online Banks)

The ideal place for your emergency fund is a high-yield savings account, particularly at an online bank.

Online banks offer better interest rates because they have lower overhead costs. They don’t have to maintain expensive branch networks.

Examples of popular online banks include Ally, Marcus, Laurel Road, Capital One, and American Express.

It’s best not to state specific interest rates, as they change. However, online bank rates are significantly higher than those offered by brick-and-mortar banks.

High-income professionals with larger emergency fund balances can especially benefit from the higher interest rates offered by online banks.

Even these rates may not fully keep pace with inflation, but they’re still the best option for preserving the value of your savings.

High-yield savings accounts offer a safe, liquid, and relatively high-yielding place to keep your emergency fund.

One thing to keep in mind is the difference between APY (Annual Percentage Yield) and interest rate. The APY accounts for compounding interest.

Best Practices for Your Emergency Fund

Here’s a quick recap of the best and worst places for your emergency fund:

Worst:

• Credit Cards: High interest rates can lead to debt.
• 401(k) Withdrawals: Penalties and lost growth can hurt your retirement savings.
• HELOCs: Risk your home as collateral.

Best:

• High-Yield Savings Accounts (Online Banks): Offer the best combination of safety, liquidity, and interest rates.
• Traditional Bank Accounts: Easily accessible, but offer low interest rates.
• Taxable Account (Low-Risk Investments): Can provide slightly higher returns than savings accounts, but comes with some risk.

Having an emergency fund is essential, but it’s equally important to choose the right place to keep it.

Key takeaways:

• Prioritize a high-yield savings account at an online bank.
• Avoid credit cards, 401(k) withdrawals, and HELOCs for emergencies.
• Be aware of the limitations of traditional bank accounts and cash.

Assess your individual situation and choose the best option for your needs.

Review your current emergency fund strategy and make adjustments if necessary.

A well-placed emergency fund is a cornerstone of financial security. It provides a safety net when unexpected expenses arise, preventing you from derailing your long-term financial goals.

Take action today to improve your emergency fund strategy. Choosing the right place to keep your rainy-day savings can make a big difference in your financial well-being.