The emergency fund is a basic risk management tool that everyone should have in place. It’s fairly simple, and easy to implement once you understand why it’s a staple for any financial plan. It’s essentially a cash pile for you to fall back on should an “emergency” ever occur, hence the name. According to Bankrate’s latest financial security index survey, 34% of American households experienced a major unexpected expense over the past year. However, only 39% said they could cover a $1,000 setback using savings. The data suggests more people need to set aside a bucket of funds for emergency expenses! This article will cover reasons you should have an emergency fund, an easy technique to hit your emergency fund goal, and the best accounts to hold the cash savings in.
Why You Should Have an Emergency Fund
Nobody plans to have to pay for an expensive trip to the hospital or major car repairs. No one plans to get laid off from their job or face a variety of other financial hardships either. The reality is, though, that financial hardships do occur, and they tend to occur when we least expect them. The best thing you can do when a financial hardship does occur is be prepared.
We use car insurance to protect against major accident expenses, home insurance to protect our homes, and medical insurance to protect our health expenses. An emergency fund is no different. We use emergency funds to protect against unexpected expenses. Expenses that could force you into credit card debt, personal loans, or even withdrawal from retirement funds.
When unexpected expenses do occur, an emergency fund can be tapped into without disrupting progress towards other financial goals and taking a step in the wrong direction.
How Much Should You Save?
Most financial planners will tell you to save between 3-6 months worth of living expenses in your emergency fund. Living expenses in this case typically allude to expenses that are absolute necessities such as housing costs, debt obligations, food, and healthcare. Dining out, new clothes, vacations, or any other variable expenses of similar nature should not be included in the 3-6 months calculation.
Depending on your job security, family situation, and other liquidity sources, the amount you should save can differ. At a minimum, you’ll want to have at least 3 months of living expenses available in cash. For example, let’s say you work in a volatile industry as a contract worker, are a single individual, and currently repaying student loans. You should consider building up enough cash on the higher end of the spectrum. Your livelihood all depends on your job and you have debt obligations. If you’re a married individual with two sources of income from different employers, have no debt, and have home equity, 3 months worth of living expenses in your emergency fund is likely adequate.
Every individual and family has a different situation, these examples are just to give you an idea of the spectrum of scenarios and the potential need for a smaller or larger emergency fund as a result.
How to Build Your Emergency Fund
First, determine what your average monthly expenses are. Check out our free financial tool that helps track monthly expenses. Or feel free to use our expense worksheet that helps drill down into specific expenses.
Once you have an idea of what your average monthly living expenses are, start saving! Whether you’ve determined you only need 3 months worth of living expenses based on your situation or 6 months. You can’t go wrong. If you eventually build up more cash than you think is necessary, you can use it for other goals. Use the excess to fund your IRA or Roth IRA at the end of the year. Or fund a taxable brokerage account. It can even be used to take advantage of the inevitable corrections in the market, allowing you to put cash to work at a discount.
If you don’t already have a savings account in place, open one. It’s hard to refrain from dipping into funds marked “emergency funds” when they’re commingled with your everyday living expenses. Once you have a savings account designated as your emergency fund, start by contributing a lump sum into the account. Start with an amount that won’t hinder your lifestyle but will be a good starting point for your emergency fund.
Next, set up automatic contributions 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 3-6 months goal. Automating contributions puts the cash out of sight and out of mind.
Before you know it, you’ll have a nice chunk of cash set aside in your savings account. As we mentioned, you may realize over time that you don’t need as much as you’ve accumulated. You can always put that cash to work elsewhere. Whether it’s paying off debt, investing it, or taking a nice vacation that you’ve earned by fulfilling your emergency fund goal!
Best Savings Accounts for Emergency Fund
You may have noticed that savings accounts at your the big banks pay a super small amount of interest. We’ve seen as low as 0.03%. The good news is there’s a better solution! 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 parking a large amount of cash for extended periods of time you might as well be earning the highest interest rate possible.
For example, let’s say you have $25,000 in cash set aside to cover 6 months worth of living expenses. At 1.45% you’re earning roughly $362.50 a year, and at 0.03% you’re earning $75. While the difference isn’t vast, it is additional money! The larger the emergency fund, the greater the savings.
It’s important to earn a decent interest rate on balances you plan on holding in cash for extended periods of time. As we know, inflation is a real thing! The cost of goods and services increases over time. In order to combat purchasing power risk, we invest our money to earn higher rates of return than inflation. While it’s not advised to invest your emergency fund, as that would effectively defeat the purpose, it is wise to earn as much interest as possible to combat the effects of inflation over time.
Need help determining how much you should have in your emergency fund? Schedule a free consultation with us today and we’ll be happy to help you determine your average monthly living expenses, how much you should have in your emergency fund, and plan for any additional goals you might have.
Levi Sanchez is a CERTIFIED FINANCIAL PLANNER™, BEHAVIORAL FINANCIAL ADVISOR™ and Co-Founder of Millennial Wealth, a fee-only financial planning firm for young professionals and tech industry employees. He is an avid sports fan, personal finance and investing geek, and enjoys a great TV show or movie. His mission is to help educate his generation about better money habits and provide financial planning services to those who want to start planning for their future today!