What Is Your Financial Burn Rate and Why Is It Important?
As a volunteer Financial Peace University teacher, my husband and I have taught several FPU courses. Once someone has met Dave Ramsey's recommended initial emergency fund of $1000 and completed the subsequent debt snowball, the next goal or "baby step" was an emergency fund of 3 to 6 months of living expenses.
A frequent question we received was how someone should determine their monthly "burn rate". Your monthly burn rate is the amount of money they'd have to spend per month to get by; that number would then be multiplied by the number of months they wanted the emergency fund to last.
The burn rate should reflect spending the categories in your four walls budget - the bills you have to pay to keep the lights on, food in the pantry, kids in daycare while you work, gas in the car and other essentials.
The calculated burn rate or spending rate shouldn't include discretionary spending you should put on hold when you're facing a job loss or other emergency.
How to Determine Your Expenditure Rate in an Emergency and Size of the Emergency Fund
Your monthly emergency expenditure rate is how much money you will burn per month when unemployed. The monthly emergency expenditure rate assumes that many luxuries like eating out, investments and frivolous expenditures are cut. The emergency expenditure rate is then used to determine how large your emergency fund needs to be.
How do you determine your expenditure rate?
- Total up how much you spend per month on average. If you don’t have these numbers on a monthly basis, total up your expenses for the past six months and divide by six. This is the starting point for estimating your monthly emergency expenditure rate.
- Subtract your pension, 401K, 529 and other saving plan contributions. In an emergency, when you are living in any degree from your savings, you should not put money into any other savings account.
- Assume that you will be making minimum monthly payments on any debts. Review your average spending level and adjust it downward if the average spending level was increased by debt payments over the minimum.
- Keep childcare, medical, insurance and food costs the same. If you know of significant ways to reduce these expenses, try to implement them on a trial basis now to determine if you can truly spend that little in these categories.
- Subtract luxury expenses that can and should be stopped when you are in an emergency. Eating out, visits to the movie theater and shopping for fun must stop. Lessons for children and club memberships may need to be cut if the emergency lasts more than a month. Remember that the priorities are keeping the lights on, water flowing, roof over your head, everyone healthy and basic essentials. Spending money now on fun risks going hungry, cold or desperate later.
- Include alimony and child support payments at their current rate when determining your monthly emergency expenditure rate. These payments require a court order to change them. If these are significant expenses today, consider setting up a legal savings account to pay the hundreds or even thousands of dollars to pay for court costs in seeking a support order modification. Research the procedures and documentation required to get a modification, in case this becomes necessary.
- Subtract income taxes from your monthly expenditure rate, since these taxes do not apply to someone living solely off of their savings. Include property tax payments in the monthly emergency expenditure rate.
- The remaining monthly expense rate is your monthly emergency expenditure rate, how much money you can expect to burn per month while unemployed.
- Multiply the monthly emergency expenditure rate by the number of months the emergency fund must last. Dave Ramsey recommends an emergency fund of three to six months. Suze Orman recommends an eight month emergency fund and a fourteen month emergency fund if you intend to start your own business.