How Big Should Your Emergency Fund Be?

Saving for emergencies should be a financial priority for anyone, but what's the smartest way to do it? Morningstar.com assistant site editor Adam Zoll recently discussed this topic with Aron Szapiro, a consumer-finance expert for HelloWallet, a Morningstar company. Szapiro recently conducted research on the swing factors that impact how much investors may want to save for emergencies.

Adam Zoll: For years, financial planners have told their clients they should have three to six months' worth of spending saved in an emergency fund. What's wrong with that basic approach?

Aron Szapiro: There are a couple of problems. It really doesn't get to the personalization that I think is necessary to figure out how much you need for emergencies.

One of the big things you're trying to do is have enough money to weather a job loss. If you think about how job loss works for a lot of couples, you've got two incomes and then you've got expenses that are probably higher than a single income. But what you really want to do is focus on replacing the higher-income person's income, should he or she lose a job. And remember that it's unlikely that both people will lose their jobs at the same time. You still have some income coming in.

You also want to account for unemployment benefits, which can vary by state.

The short answer is, there is a lot of customization and personalization you can do around an emergency-fund recommendation. And because it's so hard to save for emergencies, having an accurate target is really important so that it's a concrete goal that doesn't feel too overwhelming.

Zoll: You looked at some actual hard data to come up with your approach. Can you describe what kind of research you did?

Szapiro: Because HelloWallet's users have linked their transactions--and, of course, this data is all anonymized--I can see things like the average cost of car repairs, and what the more extreme costs look like. I can look at what people have spent on home repairs, such as expenses for plumbers or expenses for roofing repairs. I was able to use this data to see what kinds of emergencies our users face and how much they spend to resolve them.

Zoll: In your research, you've developed three different tiers of emergencies. The top tier is job loss. But how do you differentiate those lower tiers?

Szapiro: When you look at some of the existing literature that's out there, a lot of Americans couldn't come up with relatively small sums of money for emergencies. One study found that about half of Americans don't know where they would come up with $2,000 for an emergency. And we know from looking at the data that a $2,000 emergency is fairly likely. So, it's definitely important to get to that first level of savings.

Ideally, people would have a plan for more extreme emergencies, but I think it's really important to get to that first level of protection. It can really help if you're able to weather a small car repair without having to go into high-interest credit card debt or other kinds of debt.

I also think it's important to give people achievable goals as a first step, and then maybe you can move on to a harder goal, like being prepared for a major health expense. Then, of course, job loss for most people--although not all people--will be the most expensive thing to protect against.

Our users have lots of goals. They want to save for emergencies, but they also want to go on vacation. Being clear about what you'll be able to weather and what you won't be able to weather with the savings you have is important information to give people so they can decide how they want to balance their priorities.

Zoll: What are some of the swing factors that may impact the amount that I need to save for, say, a minor repair versus a more major repair. For example, if I have a more expensive home, a minor repair for me may entail saving more than for someone with a more modest home.

Szapiro: I did try to do some bifurcation there. I looked at the differences between someone who owns a home and a condo. Ideally, we would get more insight into which cars are less reliable and cost more to fix. My instinct is that the more expensive the car, the more expensive the repairs are, simply because you have more income and the income effect would suggest that you'd repair more minor things. But I did do some regression analysis to see if there were big differences between people with different income levels and the kind of money they were spending on car and home repairs, and I actually didn't see big enough differences to justify the change in recommendations at this stage.

Now the big swing factor is health care. People have very different kinds of health care that have different levels of coverage. So, for example, somebody in a high-deductible health plan is going to face much higher costs immediately for any kind of health emergency than somebody in a more traditional health-care plan with a low deductible. The out-of-pocket maximum cost someone could face might range from a few thousand dollars all the way up to $13,600, which is the maximum that can be allowed under most plans under the new Affordable Care Act. That is the really big swing factor on health care.

Zoll: Let's talk about how to put your system into practice. How do I begin assessing my emergency-savings needs based on my lifestyle?

Szapiro: We actually have a calculator on HelloWallet.com that guides you through it. Basically, we just ask a few questions. We want to know what your health-care deductible is and the maximum out-of-pocket expense. How many cars do you own? Do you own a home or condo, or do you rent? Those are the things we're looking at.

Then, also, we look at income and how much you spend so that we can get a sense of what you'd need to have to cover a job loss, and we can estimate what you'd receive in unemployment insurance as well, which is an important buffer for lots of people.

Once we go through those few questions, we can give a pretty good estimate of what it would cost to weather different kinds of emergencies.

Zoll: If I wanted to do this calculation on my own, how would I go about doing that?

Szapiro: We estimate that for a minor emergency, you want to have about $750, if you have a car. That's not going to cover major repairs, but it'll cover a lot of the minor emergencies we observed; it's a good first target. Add to that the deductible for your health insurance, which you should be able to find through your plan documents. If you have a home, we think you probably need between $1,500 and $1,800 for minor emergencies.

Then, if you move on to major emergencies, I think that you need to have the full out-of-pocket maximum for your health care. When you look at bankruptcy data, a lot of bankruptcies are caused by health emergencies for people who have insurance. These are people who have some coverage, but they have a health emergency, and in addition to all the other costs that come with the health emergency, they're not able to pay the bills, even though they have insurance. For most people, the full out-of-pocket maximum is a good target, and you'll have enough to cover the health emergency and anything else that comes up.

If your home needs a lot of repairs or if it's a very large home and there's a lot of risk associated with it, you might want to think about that, too.

And then finally, for job loss: I like to think of this as, protect yourself if the higher-income person loses a job, but you could assume that the lower-income person probably won't lose his or her job at the same time. So, you can assume that income will be available, and some unemployment insurance. And look at how much you need to have saved to meet your day-to-day expenses for a year. The reason I picked a year is, if you look at the data from the last five years, it's really not that uncommon to go for a year without a job. Having that extra money means that you won't have to take any job; you can take the right job. The time frame may vary by field. I know there are people who have jobs that are very in-demand, and they know they can find another job relatively quickly. Only you as an individual know that. But I think, as a general rule, being able to meet your expenses for a year is a very good target.