Why You Should Have an Emergency Fund

An emergency fund is a basic risk management technique. It is a cash pile for you to fall back on should a financial emergency ever occur. It's fairly easy to implement once you understand why it should be a part of your financial plan.

According to Bankrate's latest financial security index survey, 34% of American households have experienced a major unexpected expense over the past year. However, only 39% said they could cover a $1,000 setback using their savings. The data suggests more people need to set aside a bucket of funds for emergency expenses. Once you've decided on a goal for how much you want to save in your emergency fund, it's important to consider the best accounts to hold your cash savings.

Why You Should Have an Emergency Fund

Nobody plans for an expensive trip to the hospital or major car repairs. Similarly, no one plans to get laid off from their job. Inevitably, there will be financial hardships that you encounter during your lifetime and usually they happen when they're least expected. (For more, see: Why You Absolutely Need an Emergency Fund.)

The best thing you can do when a financial hardship does occur is to be prepared. If you're not prepared, the alternative is to acquire credit card debt, personal loans or to access your retirement funds prematurely. Car insurance protects against major accident expenses, home insurance protects our homes and medical insurance protects our health expenses. An emergency fund protects you from having to disrupt your progress towards other financial goals.

How Much Should I Save?

Most financial planners will advise you to save between three to six months of living expenses in your emergency fund. Living expenses are only the absolute necessities: housing costs, debt obligations, food, and healthcare. Dining out, new clothes or vacations should not be included in this calculation. 

Depending on your job security, family situation and other liquidity sources, the amount you should save can differ. If you work in a volatile industry as a contract worker, are a single individual and currently repaying student loans, you should consider saving six months worth of living expenses. 

If you're a married individual with two sources of income, have no debt and have home equity, three months worth of living expenses in your emergency fund is likely enough.

Determine what your average monthly expenses are and then save three to six months of living expenses. (For more, see: How to Build an Emergency Fund.)

How to Build Your Emergency Fund

It's hard to refrain from dipping into your emergency fund when it's not saved in a different account than your everyday living expenses, so it's best to open a savings account. Start by contributing a lump sum into the account designated as your emergency fund. Then, set up automatic contributions from your checking account for the day after you get paid every month. You'll want the contribution amount to be large enough so that you can make meaningful progress towards your goal, but not so much that it impinges on your lifestyle. 

If you eventually build up more cash than you think is necessary, you can use it for other goals. You may realize that over time, you may not need as much as you thought. You can always put that cash to work elsewhere. Use the excess amount of cash to fund your IRA or Roth IRA at the end of the year, or fund a taxable brokerage account. This amount can even be used to take advantage of the inevitable corrections in the market, allowing you to put cash to work at a discount. 

The Best Savings Accounts for Emergency Fund

You may have noticed that savings accounts at large, corporate banks pay a small amount of interest, sometimes as low as 0.03%. Online banks such as Ally Bank (which has an easy signup and user-friendly digital experience) offer interest rates around 1.45%. If you're contributing a large amount of cash for extended periods of time, you might as well be earning the highest interest rate possible. 

If you set aside $25,000 in cash to cover six months of living expenses, at 1.45% you're earning roughly $362.50 a year. At 0.03% you're earning $75. The cost of goods and services increases over time. In order to combat purchasing power risk, invest your money to earn higher rates of return than inflation.  

An emergency fund is an essential part of a financial plan. Decide how many months of living expenses are appropriate and keep your emergency fund separate from other accounts at an online bank that offers the best interest rates. (For more from this author, see: The Best Way to Budget: Automate Your Finances.)