3 Factors That Determine the Size of an Emergency Fund

Today’s article is a follow-up to another post, “5 Key Reasons to Establish an Emergency Fund Now,” which explained why you should have an emergency fund.  As promised, I will now describe the factors one should consider when determining the appropriate size of an emergency fund.  One overarching consideration is that an emergency fund should be just large enough to accomplish its purpose and no larger.  By its very nature, an emergency fund should be kept in a bank savings account.  The bank should be a prominent institution with FDIC insurance.  The unfortunate byproduct of safety is low-interest rates on deposits.  An emergency fund that is too large means that money is left on the table, not working for its owner.

So how much money should be in an emergency fund?  I’ll start with the rule of thumb: three to six months of emergency expenses.  Once past the rule of thumb, I’ll explain how to factor in insurance deductibles and copays and, finally, how to view individual and total risks that increase or decrease the size of the emergency fund.

Start with 3-6 Months of Expenses 

Why three to six months?  The idea, at its most basic level, is that most people should be able to find new employment in three to six months if they lost their job.  A realistic assessment during most normal economic times, it means that lifestyle doesn’t change drastically during the period of unemployment.  Three to six months is a wide range, though.  Individuals in a high turnover industry should be more conservative with a more significant emergency fund.  The same goes for individuals who live in areas with struggling economies.  On the flipside, people with skills in high demand or careers with relative security could get by with a smaller emergency fund.  For my military clients, I tend to start my calculations with three months of reserves.

Which expenses should we include in emergency fund planning?  Start with the basics.  How much money does it take each month to keep the roof overhead, turn the lights on, and put food on the table?  That’s a euphemism for the house payment, utilities, car payment and fuel, food, and insurance.  From that point, an individual and family could add to mandatory expenses based on the specific situation.  For example, parents might need to continue tuition or sports payments for their children’s activities.

Account for Insurance Deductibles and Co-Pays

My last post discussed how an emergency fund could free a person to raise insurance deductibles.  Over time, higher deductibles can reduce insurance costs significantly.  At the same time, though, those deductibles can quickly cut into an emergency fund if their relative size isn’t managed properly.  For example, it does not make sense to have a $5,000 homeowner insurance deductible if the emergency fund is only $8,000.

In the insurance arena, we can focus on two major events: 1. A major medical emergency and 2. Multiple property insurance claims at once or in a short period.  Health insurance, with its combination of deductibles and co-pays, is often different than property insurance due to the somewhat open-ended nature of co-insurance.  That is, even after satisfying the deductible, the insured often must make additional payments.  Most health insurance has an annual out-of-pocket maximum, though.  In other words, for a given year, an insured can only be expected to pay a maximum amount.  This amount, be it $2,000 or $10,000 should guide the size of an emergency fund, too.  It shouldn’t be added to the 3-6 months of expenses.  Instead, if the out-of-pocket maximum amount is higher than the that set aside for unemployment, then the emergency fund should increase in size.

In a similar vein, multiple property losses in a short period could run up the bill for deductibles, too.  What’s the chance of a tree falling on the garage, invoking both homeowner’s insurance and auto insurance?  Individuals and families should look at the likelihood of multiple claims occurring in a short period.  With higher deductibles, how much could that cost?  Again, if the amount is higher than what is already set aside in the emergency fund, then the emergency fund size should be increased.

Other Unexpected Expenses

This final factor is a bit of a catchall.  While I couldn’t come up with an exhaustive list, unplanned or unexpected expenses also come in areas unrelated to employment or insurance.  For example, if the car used to drive to and from work breaks down and requires expensive repairs, the emergency fund must be in a position to cover that cost.  The same goes for a flat tire.  Or the roof on the house starts to leak.  Insurance does not cover these types of events.

On the other hand, a new car or new home might be under warranty with the manufacturer picking up the repair tab for the first few years.  Understand possible costs in this catchall is more of a qualitative endeavor.  How many miles are on the car?  How old is the house?  Older things tend to require more maintenance and repair.  More expensive items tend to require more expensive maintenance and repair.

Remember, the emergency fund is part of an overall risk management process.  We can transfer some risk, especially that of catastrophic loss of property, to an insurance company.  Other risks, such as loss of employment income, maintenance and repair costs, and insurance deductibles are retained by individuals and families.  They hold an emergency fund to be able to pay these unplanned expenses if they come up.  It’s much better than using a credit card and trying to catch up after the fact while paying 20% interest.

 

 

 

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