How big should my emergency fund be? That’s a common question and it is a subject of much debate.
The rule of thumb for the proper size of an emergency fund is three to six months’ worth of spending. The concept is that this will provide a cushion in the event of an emergency: a big one like a job loss, or (hopefully) smaller ones like unexpected medical bills, car repairs, and major appliance replacements. Generally speaking, people whose income is more guaranteed/predictable, or two-income households, are directed to shoot for a lower emergency fund because their total household income has less risk associated with it, while people whose income fluctuates or who are the sold breadwinner for a family are directed to aim for a higher emergency fund because their income has more risk associated with it.
Essentially, the more your family’s livelihood is at risk if your income falters or goes away for a period of time, the higher your emergency fund should be.
That’s almost right, but not quite right.
What Is the Purpose of an Emergency Fund?
The purpose of an emergency fund is to cover your expenses in the event of an emergency, where your current income can’t cover those expenses. Duh, that’s pretty obvious. But there are really two types of emergencies.
The first is a large, unexpected expense; something like having to replace your roof after a hailstorm, having to replace the transmission in your car, or paying for unexpected medical expenses. In these instances, you still have income, but you have an expense that exceeds what you can afford to pay from your current income. So, you have an emergency fund in place to cover these expenses.
The second type of emergency is a loss of income. Your expenses don’t necessarily change in this instance, but now you no longer have the income to cover your basic expenses. This is another reason to have an emergency fund in place.
Challenges of Variable Income and Commission Income
For people with variable income, like commercial real estate brokers and other real estate professionals who may have a relatively low base pay with significant (but unpredictable) bonus potential, fluctuations in income are not a loss of income. They are an expected part of the career–they are not emergencies. But even though your income varies, your household expenses do not.
Commercial Real Estate Brokers Need an Emergency Fund…
You are not exempt from emergencies. So, you need an emergency fund, just like everyone else. And, just like everyone else, the size of your emergency fund depends on the specifics of your situation and your family, but it’s probably in the range of three to six months’ worth of your household spending. But that’s not enough.
…And They Need a Leveling Fund
What’s a leveling fund? It’s a fund to smooth out the peaks and valleys in your income. You’re going to have some big months with huge commissions. And you’re going to have some months with no commissions–but you’re still going to have to pay your bills.
To build a leveling fund, you save extra money in the big months so that you have money to draw from in the small months. Are these small months emergencies? No, because that’s the nature of the real estate business. You pull money from the leveling fund to pay for your lifestyle in the small months, and you add to it in the big months. The goal is to have a level amount of money available for your family, regardless of your commission income during any particular month.
How Much Money Should I Have in My Leveling Fund?
That’s a good question. The point of a leveling fund is to cover your family’s monthly typical expenses and savings. So, it’s not just to cover the basic needs, but to allow your family to live comfortably without undue discomfort and disruption.
Typically, this fund should be able to cover whatever is the number of months you think is the absolute highest number of months you may go without income. So, if your family’s monthly expenses are $10,000 and you think you may go for three months without income, then you should save at least $30,000 in your leveling fund. If you think you may go six months without income, then you should save at least $60,000.
If you have known, consistent other sources of income, then you may be able to have a smaller leveling fund. Remember, the goal is to always be able to provide for your family’s normal expenses and savings.
Can a Pseudo Salary Help?
Another way to handle this is a Pseudo Salary, which we cover here. In fact, this is a better way for most commercial real estate brokers to institute a leveling fund.
So, How Big Should My Emergency Fund Be?
Putting it all together, your emergency fund should be big enough to cover true emergencies, including job loss. So it’s probably in the range of three to six months’ worth of income.
But you also need a leveling fund to smooth out the natural peaks and valleys income that come with your career in commercial real estate. This is probably another several months’ worth of income.
Splitting this into two separate accounts with two separate–but related–purposes will help you with the psychology of managing your money. Helping with that psychology is a big part of what we do at Dominion Financial Advisors. We can help you put the structures in place to manage your finances today and into the future.
Schedule a complimentary consultation with us to see how we can work together to help smooth out the road ahead of you.