Emergencies happen. When they do, having an emergency fund will put you in a better position to weather the storm.
This post covers everything you need to know about emergency funds, setting one up, where to put the money and tips for building one fast.
What is an Emergency Fund?
An emergency fund is a pool of money set aside to cover unforeseen expenses from unexpected events. These events can be as minor as a car trouble, or as serious as a job loss. Whatever the event, they can be incredibly stressful and costly without a stash of money you can quickly draw on.
An emergency fund protects you against these unexpected financial surprises, and it could be the difference between a minor setback to your finances and a total disaster that takes years to correct.
Benefits of Emergency Fund: Why You Need One
Keeps your money stress in check
It gives you the peace of mind to face most of life’s unexpected events.
Emergencies such as a job loss or medical issues are stressful enough on their own. An emergency fund ensures you don’t add money problems to the already stressful situation.
Related Post: 11 Ways to Deal with Money Stress and Financial Anxiety
When emergencies hit, there may be other options to get or borrow the money needed.
But here is the problem…
These debts, like credit cards and pay-day loans, are usually at a higher interest rate. Also, if care is not taken, it may lead to bigger debt problems in the future.
Curb frivolous spending
Knowing you need to build up an emergency fund may help condition you mentally to cut back on some of your spending – especially if the fund is out of reach in a separate account.
Some Financial Emergencies To Save For
As the name suggests, your emergency fund is meant for only financial surprises. For other expected and non-regular expenses, you should be planning and saving for them using a sinking fund.
So what are some of the emergencies that you need to save for?
- Job Loss
- Emergency Medical or dental expenses
- Unexpected or higher than expected Tax Bill
- Home Repairs
- Unplanned Travels
- Car Repairs
- Emergency Pet Care
Emergency funds are not meant for:
- Christmas gifts
- Buying a new gadget
- Children’s Education
- Routine or minor car or home repairs
Who Needs an Emergency Fund?
An emergency will affect people in different ways financially. Some severely, others with little impact.
In fact, it can be argued that some people don’t need to have one.
But if you belong to any of the groups below, then you need to prioritize building an emergency fund.
1. You have only one source of income
On the average, it takes about 20 weeks for Canadians aged 25 and above to get another job.
That’s 5 whole months of no income! An emergency fund will be a life saver in such a situation.
Of course, depending on a number of factors like your experience, skills and industry, the time may be shorter or longer.
Fortunately, you may be able to claim some employment insurance, but it may not be enough in many cases.
2. You are a contractor or self-employed
If you’re self-employed or a contractor, it is important to have enough emergency fund in place. This is especially true if you’re in a field that experiences a boom and bust cycle – that is, you have busy periods where you make lots of money, followed by a silent or slow period.
3. You, or a dependent, have a medical condition
While you may be covered by some health insurance, depending on the health situation, you may have to pay some cash out of pockets or unable to work during the period.
Having some pool of funds stashed away will let you sleep a little easier.
Other groups of people that may benefit from having an emergency fund are homeowners, families with a single earner, those living far away from their families or in another country and so on.
How Much Should You Have In Your Emergency Fund?
The rule of thumb is to save enough money to cover 3 to 6 months of essential expenses. This is a good starting, but it may be too much or too low.
Like many things in personal finance, how much you’ll need depends on your own personal circumstances. You need two variables to get an estimate of the amount to set aside: Monthly Expenses and Number of months of expenses you need to cover.
You will need to get an estimate of your living expenses per month. If you’re married, consult with your spouse and make this a joint exercise.
Only include essential expenses such as
- Housing and Utilities
- Health care
- Debt repayment
- Insurance payments such as life insurance payments
Also, remember to account for those irregular or annual expenses like insurance premiums if you pay annually, professional membership dues and so on
What about child-care expenses? It depends on you. If you lose a job, you may be able to take care of your kids on your own during this period and arrange for temporary care if you need to go for an interview. But it’s best to discuss it with your spouse.
Other non-essential expenses should be excluded for this exercise. When money is tight, some expenses will naturally be cut out. They include:
- Dining out or ordering take-outs
- Entertainment costs like going to the movies
- Saving for a second car and other financial goals
Number of Months
Once you have an estimate of how much you’ll need per month, here is a quick and general guide you can use to determine how many months of expenses to cover:
3 months: If you have a job that can be easily replaced and single with no dependents or married but your spouse’s income can cover your family’s monthly expenses
6 months: By default, many people should work towards this. As mentioned earlier, it can take up to 5 months to get a new job, or even longer.
9 months: If you’re self-employed, consultant or freelancer with large swings in your income. People whose income are commission-based or work in a high-risk industry will also fall into this category.
Remember these are just suggestions, be honest with yourself and work out the number that is best for your circumstances.
Also, consider what could happen if you lose your job during a pandemic or recession. With many people searching for a new job about the same time, what would happen to your chances of getting back to work sooner?
Once you have those 2 variables, you can go ahead to calculate how much you need to have in your emergency savings by simply multiplying them.
How long should I use to save for an emergency?
Even if you only need to cover 3 months expenses, it may still be quite daunting to put that money aside at a go or over a few months. In most instances, it may take a year to two to get to the target amount.
But the starting point is to draw up a SMART plan that you can easily follow. And it is okay to start small. In fact, set a small target of stashing away the first $1,000. Once completed, move on to the next target.
The best practice is to set up a direct deposit. It’ll help you automate your savings and leave out your emotions. The fewer decisions you need to make, the less frictions there’ll be and the more you’ll end up saving.
Look at your finances and work out how much you can save weekly, biweekly, or monthly. If you save $50 weekly, you will have $1,300 after a year, or $2,600 if you can save $100 every week – ignoring interest and inflation.
In addition, put any extra money you make such as a bonus, tax refund, income from a side gig or gift into your emergency fund. You need to prioritize it and be intentional about getting to your target amount.
In summary, here’s how to build an emergency fund:
- Estimate how much emergency fund you need by
- Calculating your monthly living expenses on essential items (housing, transport, feeding and so on)
- Working out how many months of expenses you need to cover
- Develop a plan and set goals to achieve it
- Start small
- Open a high yield savings account if you don’t have one already
- Set up direct deposit
- Top up your savings with any extra income
Where Should You Keep Your Emergency Fund?
Emergency funds are meant to be liquid and easily accessible when you need it.
In deciding where to put your emergency fund, here are 3 factors you should consider:
- Ease to access: The fund should be readily available for you to withdraw quickly. For example, putting all your funds in a non-redeemable GIC will be a bad idea. Even if your financial institution allows you to withdraw it, it may come with some penalty and take a while.
- Protection from market volatility: Save your emergency fund using an investment that’s protected from market risk. Imagine needing your money in an emergency and it is down 20%.
- Decent interest rate: Shop around and get the best interest rate on your funds. Often, this will mean opening an HISA at one of the online banks or credit unions.
Some Options for Saving Your Emergency Fund
Save it in a High-Interest Savings Account (HISA)
When it comes to saving for emergency fund, the safety of the money is more important than the interest you make on it.
But this does not mean you should put it in a regular savings account at your bank. Consider opening a HISA with one of the online banks or credit unions.
You can get an attractive interest rate of 1.25% at EQBank (at the time of writing this post), compared to just 0.05% regular interest rate from the big banks.
The only challenge with saving your money in a HISA is: you’re sacrificing growth and your money is losing value due to inflation.
Invest your Emergency Fund
For you to have any chance of beating inflation, you need to get an attractive return on your funds. Inflation is currently about 2% in Canada, and there’s no way you’ll get a higher rate from a regular savings account from any of the big banks.
In fact, you’ll be hard pressed to get a 2% rate from a HISA at the moment (August 2020), except for a few promotional or welcome offers for new customers that last for few months.
Historically, investing your funds in the stock market will give you higher returns but you’ll be subjected to higher volatility. Your investment may be down substantially when you need it.
Imagine losing your job during the Covid-19 pandemic and you needed to sell some of your investments to fund your living expenses?
Related Post: How to start investing in Canada for Beginners
A Hybrid of the two
Rather than choosing between saving in a HISA or investing your money for better returns, you can take a hybrid approach where you split your funds between the two.
With this approach, you’ll be balancing safety and better returns.
To illustrate: If you need an emergency fund to cover 6 months of living expenses, you can
- Save 3 months worth of expenses in a HISA. This will take care of the first few months’ living expenses
- Invest the balances in the stock market. To keep things simple and save on commissions, you can buy an asset allocation ETF, ideally in a balanced fund. For your other investments, you may be fine with a higher exposure to equities, but you need to reduce the risk your emergency fund is exposed to.
Tips To Build Your Emergency Fund Fast
Here are a few tips to use to quickly build your emergency fund:
- Make extra money with a side hustle
- Get a head-start with money from windfalls (tax refunds, bonus, gifts and so on)
- Automate your deposits by setting up pre-authorized deposits
- Track your spending
- Build a budget
- Plan ahead for big expenses and purchases
- Use Credit Wisely
- Reduce impulsive buying
Emergency Fund and Other Financial Goals
Money is a finite resource. Each dollar you put in your emergency savings is a dollar not going towards your other financial goals.
So how do you manage building your emergency funds and other goals?
If you have debts, especially the ones at higher interest rates like credit cards, a better use of your limited income will be to prioritize paying down those debts.
Like Dave Ramsey recommended in his baby steps, you can start with $1,000. Then pay off all your debts except your mortgage, before moving on to saving for your emergency fund.
The $1,000, or any little amount you choose, will be a buffer and will come handy for little emergencies.
Alternately, focus on setting aside enough money to cover a month’s expenses then prioritize your debt repayment.
The more debt you have, the less flexible you’ll be if an emergency hit. So you should prioritize debt repayments or get them under control before thinking of emergency funds.
Do You Need An Emergency Fund?
No doubt, having some form of emergency savings is prudent but not everyone needs it – at least not to the level of having enough money to cover 3 months’ expenses or more.
You may not need an emergency if:
- Your job is very secure or in demand and you would be able to quickly replace it
- You work in a stable industry
- You have multiple sources of income and losing one source will not put a significant dent on your finances
- You’ve been able to amass enough savings and investment that you can easily access in an emergency. In Canada, this could be funds in your Tax-Free Savings Account (TFSA) or even RRSP. You can withdraw without any penalty from the TFSA, but you’ll pay a withholding tax for RRSP withdrawals.
Even for those in these categories, having some cash for emergency spending is prudent. So rather than putting the money in a savings account, you can invest it in a balanced fund.
Some other alternatives to an emergency funds are:
- Employment insurance (if you qualify)
- Withdraw from your investment accounts
- Insurance, for example medical insurance
- Credit cards, but beware of the high interest rates.
Final Thoughts on Emergency Funds
Whatever the emergency or surprise life throws at you, having an emergency fund may help you get through without a significant and long-term damage to your finances.
But if you already have enough savings and investment that you can access quickly, then having an emergency fund may not be necessary.