Emergency Funds

One of the common myths about emergency funds has to do with the size of the fund. The traditional rule of thumb was to save three to six months of income. It's difficult to justify a rule of thumb that involves income, since the money is used to pay for expenses. From this point forward, we'll be talking about expenses, and not income.

Essential Monthly Expenses

Think of essential expenses as the last costs to be eliminated. For example, anyone with a secured loan such as a mortgage or car loan needs to make their monthly payments or they lose something important. Groceries are another example of essential household expenses: everyone needs to eat. Additional examples that fall into this category include:

• Living Expenses: includes mortgage and rent payments, real estate or property taxes, homeowners insurance premiums, as well as household repairs.

• Travel Expenses: includes monthly car loan or lease payments, car insurance premiums, gasoline or fuel costs, and car repairs.

• Personal Expenses: includes personal and / or student loans, life insurance premiums, medical as well as dental insurance payments.

• Household Expenses: includes household operating costs such as electricity, natural gas, water, telephone / cellular phones, internet access, sewage, and waste disposal fees. Also includes food purchases, as well as essential credit card payments.

Discretionary expenses are those families could do without, or give up, without too much pain. Discretionary expenses include entertainment, recreation, vacations, subscriptions and luxury items.

While an emergency fund can be used for several types of financial tragedies, the loss of household income often places the greatest burden on a family's finances. That's the primary reason the size of a fund should be based on the length of time a person is likely to remain unemployed.

A common rule of thumb is to set aside four to six months' worth of salary in case of a financial emergency. This approach is flawed

Moneyzine Editor

Fortunately, unemployment statistics are frequently published by several U.S. government agencies. Using this data removes most of the objectivity from the emergency fund calculation. The data can also help dispel some myths concerning the relationship between income and unemployment duration.

Myth #1: Age and Duration

This first myth goes something like this: The older you are, the longer it takes to find a job. According to a study published by the U.S. Census Bureau in March 2006, the median duration of unemployment in the group studied was 2.4 months. The shortest duration was 1.8 months for 16-to-19-year-olds, while the longest was 3.1 months for people aged 45 to 54. While there certainly is a difference between these two groups, the difference is a little over one month. That's not going to make a big difference when calculating an emergency fund. So we're going to dispel the myth that age needs to be considered when calculating an emergency fund.

Myth #2: Income and Duration

The second myth goes something like this: The more money someone makes, the longer it takes to find a job. It's been widely demonstrated that income rises as the level of education increases. So if the above myth were true, we'd expect the median duration of unemployment to rise with educational attainment. Fortunately, the Bureau of Labor Statistics measures unemployment duration by education. The table below contains the average duration of unemployment by education from the year 2006 through the first six months of 2010.

Duration of Unemployment (Months)

In each of the years in this table, the pattern is the same. The higher the education of the individual, the easier it is to find a job. This data clearly dispels the myth that higher income individuals have a harder time finding a job. So what do we know so far?

• Income has nothing to do with the size of an emergency fund.

• Age, and therefore the number of years in the workforce, has only a small influence on the duration of unemployment.

• Individuals that have a college degree will find a new job faster than individuals with lesser degrees.

Any calculation that uses factors such as income, salary, or the years of employment is clearly wrong and will provide misleading results. There are only two factors needed to project the appropriate size of an emergency fund: essential expenses and unemployment duration.

Unemployment Duration

Let's look at some of the unemployment data gathered by the Department of Labor (Bureau of Labor Statistics). We'll use that data to determine the duration of unemployment, which is the second value we'll use to calculate the size of an emergency fund. The Bureau of Labor Statistics has information concerning the duration of unemployment going back to 1962. In this exercise, we're going to use data from 2005 through 2009, a timespan that covers the Great Recession.

Duration of Unemployment

The above table provides two different types of information. The first is the median duration of unemployment. As a reminder, the median is the midpoint in the data. For example, in 2009 the table tells us that 50% of unemployed individuals were looking for a job for 15.1 weeks and 50% of the unemployed that year were looking for more than 15.1 weeks (around 3.5 months). The second set of data in the table is the percentage of unemployed for each duration period. For example, 32% of individuals took more than 27 weeks (around 6 months) to find a job back in 2009. The Great Recession was an extraordinary time in terms of unemployment. Looking at the pattern in the above table, it's possible to draw a generalization:

• There is a 50% chance that the duration of unemployment will be less than 9 weeks (around 2.5 months). Therefore, the minimum emergency fund should be equivalent to three months of essential expenses.

• There is an 80% chance that the duration of unemployment will be less than 27 weeks (around 6 months). Therefore, the optimal emergency fund should be equivalent to six months of essential expenses.

It's possible to run through some "what if" scenarios using our online emergency fund calculator. That tool was built based on the data and methodology described in this article. The calculator allows the user to input their essential expenses and provides an estimate of both the minimum as well as optimum size of an emergency fund.