The following is a post by MPFJ staff writer, Kevin Mercadante, who is professional personal finance blogger, and the owner of his own personal finance blog, OutOfYourRut.com. He has backgrounds in both accounting and the mortgage industry.
There are all kinds of methods that are used to determine what the proper size of an emergency fund should be.
Perhaps in an attempt to simplify the process, the most common recommendations are for either a flat amount – say $1,000 – or a certain number of months living expenses, which typically ranges anywhere from one to six months.
In reality however, determining the right size for your emergency fund may not be all that simple. A flat amount or so many months living expenses will work only in the most general sense. Your method also needs to account for the variables of life. And one of the biggest variables is the stability of your income.
It isn’t possible to have the right-sized emergency fund unless you adequately adjust for qualitative factors, one of which is income stability. How should income stability affect the size of your emergency fund?
Types of income that should affect the size of your emergency fund
Evaluating the stability of income is mostly a matter of considering the source. A salaried position with full employee benefits would represent the most stable source of income. This will be especially true if the job is in a professional position, such as nursing, accounting or teaching. Government jobs tend to be even more stable, since layoffs from such positions are infrequent.
At the opposite end of the spectrum, are employment situations in which all – or at least a substantial amount – of your income is derived from non-salaried sources. Some examples might include:
- Self-employment
- Commission sales jobs (100%)
- Salaried jobs in which a substantial amount of compensation is derived from bonuses, commissions, or overtime
- Contract employment
- Hourly positions with variable schedules (includes most part-time positions)
- Seasonal jobs
Another type of employment with unstable income includes jobs with a high frequency of layoffs. An example of this would be many positions in the building trades. Since the construction industry in general tends to run with the boom and bust cycles of the real estate business, building tradesmen qualify as having less stable income sources.
Now that we’ve set some definitions for what constitutes income stability, and which income types they apply to, let’s get back to the question of how much to have in an emergency fund.
Greater income stability requires a smaller emergency fund
If you are on the high end of income stability – let’s say that you have a full-time, fully benefited job with the government, and you even have some tenure. If that is your situation, then you can be on the lower end of the emergency fund scale. Given that financial planners usually advise having something like 3 to 6 months of living expenses in your emergency fund, the stability of your income would allow you to keep your fund at the lower end of the range. You would likely be perfectly safe with just three months reserves, and you may even be able get away with a little bit less. For most people, the biggest emergency situation is the loss of a job or the potential for a serious reduction in earnings. But if your job and income situations are extremely stable, then that potential emergency will not be a reasonably likely scenario, and your emergency fund doesn‘t need to be as large.
Less income stability requires a larger emergency fund
It’s easy enough to see how a very stable income situation would require a smaller emergency fund. But the situation gets a bit more complicated when you’re talking about less stable income sources, such as the ones listed earlier.
If you are in a situation that is generally unstable income-wise – or at least has the reasonable potential to be so – you will want to be at the higher end of emergency fund recommendations, at the very least. In just about any of these income situations you should have at least six months of living expenses in your emergency fund.
If you’re income situation is at the high end of unstable – such as self-employment or 100% commission – you may want to increase your fund to cover as much is 12 months of living expenses. The larger emergency fund is necessary not only to compensate for potential loss of income, but just as important, to give you some peace of mind during periods of wide income fluctuation. If you have enough money saved to cover your living expenses for a year, you should be able to keep calm and to do whatever is necessary to turn your income situation around.
Still another benefit of the larger fund – from my own personal experience – is the tendency for other emergencies to develop when you’re dealing with an income crisis. Blindside disasters just seem to be more frequent when income is low. There’s nothing really scientific about how much money to have in your emergency fund. And there are different ways to calculate how much you’ll need. But whatever method you take, you should seriously consider your income stability as a major part of the criteria.
How about you all? What factors form the basis for the selected size of your emergency fund?
Share your experiences by commenting below!
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