In our previous Cash and CDs post, we discussed the reality and perception of the yield on cash and CDs. At after-inflation rates below zero, many people are wondering where to put their cash reserves. Here are a few common questions that we have been hearing:
Q: What should I do with cash or money markets?
A: The answer to this question is not the same for everyone. In general, time frames and objectives for the cash will play a role in the appropriate answer for each situation. The most common use for cash is an emergency fund. We recommend a minimum of 3-6 months of living expenses within an emergency fund. If this amount matches your cash reserves, then you are well served by leaving these funds alone. The goal of an emergency fund is to have the money available, NOT investment return. In fact, an emergency fund should never be at risk for loss of principal.
Beyond emergency funds, there may be other short-term objectives for your cash and money markets. If your time frame is less than 3 years or you feel most comfortable with a sizable cash reserve, a money market or CD may still be the best option for your funds. However, this does not mean you have to park your funds in a 0.000001% yielding savings account. If you are willing to bank online, there are several “online-only” savings accounts which offer a more generous rate. These banks will also carry FDIC insurance.
Q: Are CDs a bad investment right now?
A: Long-term CDs are not likely a good investment with interest rates at historic lows. The reason, outlined in Part 1 of this blog, is the inflation which will erode your purchasing power. Locking in CD with a low interest rate for 3, 4, or 5 years will guarantee a low rate for the entire term. Since there is a reasonable chance that interest rates are higher in 2 or 3 years, you may be able to lock in a better rate by waiting in shorter term CDs or money markets like the ones mentioned above. In any event, you don’t want to lose the flexibility to invest elsewhere or at a higher rate by putting funds in CDs with maturities greater than 2 years.
Q: When are interest rates going up?
A: This is of course the magic question on everyone’s minds. Predicting interest rates is no easier than predicting the stock market, thus we do not try. However, we can observe that interest rates have hit all-time lows and they’ve been low for longer than most investors expected. Returning to a “normalized’ level is bound to happen when the economy improves. The last few months have seen a measurable increase in interest rates, as the Federal Reserve has indicated that they may be stopping some methods to stimulate the economy (which had been keeping interest rates low). While this doesn’t indicate the Federal Reserve has seen a full economic recovery, it does indicate that they are continuing to see signs of a gradual recovery. The rest of 2013 should give us a good idea of whether or not we’ve hit an inflection point to start a new trend of rising interest rates.