The Ultimate Emergency Fund
Emergency/Opportunity fund? Which, What and Why?
Imagine a pendulum swinging back and forth, slowly drifting from one extreme to another. Our lives are similar to this pendulum – we all have highs and we all have lows. Unfortunately, we often cause the most financial damage to ourselves when we are at are lows (e.g. getting into debt), and often don’t make the best of our opportunities when we are at our highs (e.g. not negotiating to maximize value). To counter this phenomenon, we can create emergency and opportunity funds for ourselves.
It’s quite simple really, an emergency / opportunity fund is any amount of money you have stashed away that has little risk of decreasing in value or being stolen. It’s similar to your “savings”, except the intent for use behind the fund is different.
Typically, the main reason to have an emergency fund is to prevent a sudden loss of income from negatively affecting your life. The intent behind the opportunity fund is similar but adds another dimension. The opportunity fund’s purpose is not only to limit your downside in life (like an emergency fund) but also magnify your possible upside. For example, say you got an amazing new job offer across the country. The opportunity fund can be used to pay for all of your moving expenses so that you can accept the job. Here, you are using your money to not save you from financial ruin, but rather to strengthen your financial future. Or perhaps the stock market crashed and all of the “blue-chip” stocks are extremely undervalued. An opportunity fund in this case could be used to purchase those stocks and reap a hefty return.
Ultimately, the opportunity fund allows you to take advantage of existing opportunity in your life. When you have an emergency, the opportunity fund creates the opportunity to not get screwed financially. When you are faced with an opportunity, the opportunity fund gives you the financial fuel to make the most of it.
Personally, I only have an opportunity fund because it doubles as an emergency fund (and because I can’t actually afford to have a second “fund” at this time). However, I would recommend both if you could afford it. Should you only be able to create 1, I would recommend the opportunity fund.
How much should you have?
Most people recommend 3-6 months worth of your personal expenses, but to be frank, it doesn’t matter. The important thing is just having a fund, even if it’s only $25. Once you’ve created the fund, you can always add to it later. The hard part is simply getting started and committing to fuel your fund. I’ve put away 5K in mine, but the perfect amount is a mix between what you can afford and what you feel comfortable with.
I believe the most risk-adjusted financially efficient (most gain for the risk you take) place to store an emergency fund would be in a 1+ year old I-bond. Here are some of the reasons I believe so:
- Tax Advantages
- Zero Inflation and Interest rate risk
The I-bond and its near zero liability
Before we discuss the I-bond in detail, take a look at the graphic below to get a birds-eye view of what it is.
Hopefully, the info-graphic above was easy to understand. In case you don’t know, a bond is a debt investment where you loan money to someone. Then, the person who you loaned money to pays you interest, and then, after a certain amount of time they will pay you back the principal on the bond (which is the original amount you loaned them). For example, you loan a friend 1,000 dollars. Your friend pays you 5% interest, giving you 50 dollars per year. After some time (say 5 years) he pays you back the original 1,000. That’s how a bond would work out. However, I-bonds are very unique because they offer very specific liquidity and tax advantages that other bonds lack.
How the yield (interest rate) is calculated
The treasury calculates the yield on a savings bond by combining two separate yields, a fixed rate and a variable inflation rate. The fixed rate is based on the prevailing interest rate at any given time (As of now, the interest rates have been low for a long time because the FED has kept rates near zero ever since the financial crisis in 2008). The variable rate is based on inflation. Inflation is measured by increases in the consumer price index (which is a number that measures how the prices of basic goods change over time). One thing to note is that we can have negative inflation (also called deflation). In this case, the I-bond yield will still be the sum of the fixed rate and the variable inflation rate. If the sum is less than zero, then the government will simply not pay you any interest – they won’t take your money from you.
Unlike other bonds where you must wait for your debtor to pay you back your principal, you are in control as to when you can cash in your I-bond, (so long as you hold it for 1 year). For example, if you were to go buy a regular 5 year bond, you would be forced to either sell the bond (to the market) or hold it for 5 years in order to regain your principal investment. With an I-bond, this is not the case, as you can choose to liquidate it at any time (granted, you will pay a small 3 months interest penalty if you cash it in before 5 years). This is important because it gives you control over your investment and stops outside forces from lowering the value of your bond.
As a matter of fact, you can make your I-bond emergency fund even more liquid by breaking it up into small chunks. For example, if you have a fund of $5K and you end up needed to spend $1K, you would have to cash in your entire bond to get a thousand dollars. Instead, you can buy 10 $500 I-bonds and simply cash in 2 of them to get your $1K when your crisis arises, thus leaving the fund largely intact.
All of the interest that you earn on your I-bond goes straight back into the I-bond. Basically, every penny you earn on your I-bond is automatically reinvested into the I-bond. What this means is that your interest will earn interest and your balance on the bond will grow exponentially (instead of linearly).
No Interest Rate Risk
Let’s go back to the previous example and add some details. You bought a 5 year bond for $1,000 that pays you 5% interest per year. This means that every year you earn $50 from the bond. Now, after your first year holding the bond, the market interest rate increases from 5% to 10%. Now, there are new bonds on the market that pay 10% interest. Had you waited a year and bought this bond, you would be earning $100 year in interest. In comparison, your 5% bond sucks verses the 10% bond. This makes your bond go down in value because it could be earning 10% instead of 5%!
The I-bond eliminates this risk because you can cash it in at any time after 1 year. Let’s say you bought an I-bond that pays 5% and the prevailing interest rate rose to 10%. Now, instead of being stuck with your I-bond, you can cash it in and switch over to new bonds that pay 10% interest. Because of this option, the I-bond will never drop below its face value.
No Inflation Risk
Let’s imagine again that you purchased a bond for $1000 that pays 5% interest. In the case that inflation kicks up rapidly and goes to 7% per year, the bond that you have is actually making you lose 2% per year. I-Bonds respond to this by increasing their interest rate to match inflation so that even though you are losing principal, you are gaining interest. However, I do want to qualify this statement. In the case of hyper inflation, you will probably end up losing money equal to the % you pay in federal taxes. If hyper inflation occurs, the government will have to increase the rate so much that most of money present in the bond will be earnings instead of principal. The government only taxes your earnings, not your principal, so if the majority of your investment is comprised of earnings, you’ll be paying more taxes.
I-Bonds are immune to state and local taxes, and defer federal taxes. This means that you won’t pay your state anything on your I-Bond earnings, and won’t have to pay the federal government anything until you cash the bond in. Other vehicles like savings accounts or CD’s are taxed by both the state and the federal government, and do not allow you to defer the taxes. To better understand this advantage, lets compare the growth of a $10,000 deposit between savings account, I-bond and CD (A CD is essentially a contract with your bank where you will deposit money for a specified amount of time and not touch it. For example, a 5 year CD means that you will leave your money with the bank for 5 years).
I-bond Vs Saving Account Vs CD
Before we do an earnings comparison between the 3, lets take a look at this graphic to get an overview of the pro’s and cons of each vehicle.
The current yield for an I-bond is 2.76% (as of 11/1/2016), whereas the top national yield for a 5 year CD is around 2.27% (as of 11/1/2016), and the top national yield for a savings account is 1.26% (again, as of 11/1/2016). So, lets get into some graphs to show 5 year growth with the following assumptions:
- I-bond yield will be about 2% (since this is the United States historic average for inflation) and will be taxed at 25% at the end (25% is the marginal federal tax bracket for the average American)
- The CD will earn 2.27% and will have its earnings taxed at 33% (median marginal tax for average Californian)
- The savings account will earn 1.26% and will have its earnings taxed at 33% (median marginal tax for average Californian)
As you can see, the I-bond and CD end up earning about the same amount even though the I-bond earned a lower interest rate. This is due to the tax advantages you get with an I-bond. Another thing to note is that the I-bond is significantly more liquid than the 5 year CD. Although you do face penalties withdrawing both the I-bond and the 5 year CD before the 5 year term, the consequences for doing so on the CD are much harsher than the mere 3 month’s interest you would lose with an I-bond. In a sense, the I-bond is like a hybrid between a CD and a savings account, offering the best of both worlds.
Negate non-liquidity with a 12 month 0% APR credit card
Unfortunately for most people, the fact that your money gets locked up for a full year is going to be a deal breaker. What if you need your money 6 months from now and its locked up in a bond? Well, you would be screwed. However, there is a loophole you can use to get around this fatal flaw – simply sign up for a 12 month 0% APR credit card.
The situation would go like this: You, the I-bond investor (yes, you are technically an investor if you buy an I-bond) come across an unforeseen tragedy. You simply pay for it with your credit card and then make monthly minimum payments. If you make the monthly minimum payments on time (every single time), you won’t pay a dime of interest over the life of the loan because near the end of the 0% APR period, you can cash out your I-bond to pay off the debt in full.
Just remember to be responsible with your credit card!
But…I can’t get a 12 month 0% APR!
If you have bad credit, or simply don’t trust yourself with a credit card, there’s still a way for you to invest in I-bonds while remaining liquid, its just going to take more effort and more time. All you have to do is follow these 3 steps:
- Save up enough for a bare-bones emergency / opportunity fund. (Whatever dollar amount you want to save is completely up to you $25, $1K, $5K, etc.)
- Invest everything you save over your bare bones emergency limit into I-bonds.
- Once you have as much money in I-bonds as in your emergency fund, and the I-bonds have been held for at least a year, you can now get rid of your emergency fund and spend/invest it.
How to get started
First off, you need to make sure that you satisfy the requirements to own an I-bond. As of right now, you must have a social security number / tax ID and satisfy at least one of the following:
- You have US Citizenship
- You are a US Resident (basically someone who has a “tax home” in the united states. This term is really vague, but if you want to learn more about it check out this document)
- You are a Civilian employee of the United States (i.e. you have a government job)
You will also need your social security number and bank account information (bank account number, routing number, you know, all the good stuff).
Then you will need to sign up for an account over at treasurydirect.gov. You’ll have to strain your eyes and click the really tiny apply now button at the bottom of the screen.
After that, you’ll be taken to a screen to identify whether you are an institution or an individual. If you are buying these bonds for yourself, you are an individual. Just go ahead and click the small submit button at the bottom.
Then you’ll be taken to a scary screen that asks you for all your personal information. Do note you can sub in your Social Security Number for the blank that says “Taxpayer Identification Number” (I had to email the government to confirm this because I was worried. In case you are too, you can check out the email here).
You click submit and then go to a page where you pick a security image and a caption. After that, you pick a password for your account, and viola, you are done. However, to log into your account, you’ll have have to use an account number and *one time password* that the treasury emails you. Overall its not very intuitive and requires some effort on your part, but it’s not difficult by any means. If you get stuck, go ahead and call 844-284-2676.
Opportunity / emergency funds are an excellent tool to remove risk from your life and amplify your possible upside. Although the I-bond place a 1 year lock on your money, it offers excellent benefits and has nearly no risk of losing value. These factors combine to make it an excellent location for an opportunity / emergency fund.
Pro Tip: Purchase your I-bonds at the end of the month because the government will pay you interest on your bond as if you had bought it at the beginning of the month.