Hello long-lost friends! I am back after a couple of weeks of studying, exams, and wedding travel. And since my last two weeks have been somewhat chaotic, it seems like a good time to talk about how to keep your financial sanity during times of surprise expenses.
The issue of emergency funds among personal finance bloggers tends to be a bit divided – with some of the opinion that emergency funds are crucial and others writing that they are not necessary at all. While there are compelling arguments for both sides, I must admit that I am in the first camp – for me, an emergency fund is a must-have.
The good news about emergency funds in Canada is that Canadians have an average of $41,694 in emergency savings. That’s awesome.
The not-so-good news is that a quarter of Canadians don’t have anything set aside for emergencies at all. And of those who do, almost half have less than $5000 saved. Not awesome. (source)
So, the basics: what is an emergency fund?
While it sounds intuitive – an emergency fund is a fund for emergencies – the emergency fund sometimes ends up as a catch all for anything you forgot to budget for. And while it is not a bad idea for you to have “things I forgot to budget for” savings, this should not be your emergency fund.
An emergency fund is easily accessible money that you can use in the event of a real emergency; what constitutes an emergency depends on your life circumstances, but for most Canadians, medical expenses, job losses or unexpected home or auto repairs are the top concerns.
It’s a cushion and a security blanket. If something unexpected happens and you get hit with a big bill or a sudden financial need (need, not want), you’ll have the peace of mind knowing that your emergency fund will be there to help you, and that you won’t compound the financial emergency by also increasing your debt.
When to save for your emergency fund?
When you have little to no debt. If you’re sitting on a big student loan or high credit card debt, your money is better spent paying down what you owe. Your debt is a liability and an emergency fund isn’t going to help you much until that’s gone.
While some suggest paying off all (non-mortgage) debt before starting the emergency fund, I’m of the opinion that setting aside small amounts (I’m talking $20 – $50 a paycheque) is okay if you have only low-interest (<5%) debt or if you have only a small amount of debt remaining relative to your income, and you have a solid plan for repaying it.
If you’ve been following my story, you know I have just under $4000 in student loan debt remaining. I’ve had an emergency fund since before my student loan debt, and I used some of it to pay my loan down, but with my low interest rate and the relatively small amount remaining, I don’t want to be derailed in my progress by unexpected expenses. Putting money aside into an emergency fund at this point protects me from having to rack up more debt and keeps me on track to paying off what I have.
You might be thinking that I could pay off my loan slightly faster if I put that extra bit of money down on the debt and you’re not wrong, but for me, putting my e-fund contributions toward my student loan wouldn’t even shave off one month’s payment so it’s getting better value where it is.
Where to save your emergency fund?
Since the key feature of an emergency fund is that you have quick access to it when you need it, there are a few options as to where you can save your “in case of” dollars.
Keep (at least part of) it in cash.
By this, I don’t mean “under your mattress” cash, but accessible through a cash account; something that you can easily withdraw from or transfer out of, but that is ideally not linked to your debit card. This could be its own unique account, or a set amount included as part of a general savings account – whatever works best for you.
You get smaller returns in these types of accounts, but an emergency fund is not necessarily meant to provide you with investment income as its primary job – you should have other accounts doing that, while your emergency fund is a “reserve” account that you probably don’t want to take any risks with.
Example: high interest savings account or TFSA as a high interest savings account
If you don’t have any debt, you have a decent sized emergency fund, and you’re in a relatively stable life situation, you might decide to split your emergency fund – keeping a portion of it in immediately accessible cash and the remainder in an investment account that’s a bit more out of reach. This is a good option if you think you’ll be tempted to use your emergency fund for things that aren’t exactly emergency funds (gifts are not emergencies) and also if you don’t like the idea of sitting on cash with only small returns.
Example: GICs/low risk TFSA mutual fund account + your high interest savings account.
If you’re going this route, make sure you have enough in your cash account to act as a buffer for the amount of time it takes to get your money out of the investment account.
A note about credit…
I have an accountant friend who is my go-to when I want to chat finance. He thinks emergency funds are dumb because, as he says, that’s what lines of credit are for. He’s not alone in this thinking, but I can’t help but disagree – to a point.
I have a line of credit and I like the peace of mind I get knowing it’s there. But if I’m in a financial emergency, I don’t want the added stress of going into debt (even with low interest) in order to pay for it. My emergency fund means I don’t have to “owe” anything to anyone but myself if an emergency happens. So while I agree that lines of credit or credit cards are useful in a pinch, I’m a believer that these should not be your only sources of funds in the event of an unexpected cost.
If a big student loan or other debt load is keeping you from building up an emergency fund, having a line of credit is not a bad idea in principle so that your cash goes toward your debt, so long as you are disciplined about what your definition of “emergency” truly is and you start building up a cash fund once your debt is paid off.
How much to save in an emergency fund and how to start?
This is where things get really divided amongst personal finance sources. While some recommend three to six months of income, I tend to go with the three to six months of expenses benchmark.
Saving a few months of income if you have the means, is an awesome idea. If you’re just starting out though, it can be intimidating when you consider that the average household after-tax income for Canadians is $76,000, so your 3-to-6 month income fund is anywhere from $19,000 to $38,000. That’s big, so to get started, break it out into smaller goals.
First, track your monthly expenses. Figure out what your annual fixed and variable expenses add up to, and divide that number by 12 to get your monthly expense total.
Initially, these expenses can be just a skeleton crew.
If you lose your job and need to rely on emergency funds, you’re likely cutting out any unnecessary spending, so things like going out for dinner, the fancy internet package, and even savings for “wants” like new cars or vacations don’t need to be included in your emergency fund calculations up front.
Once you’ve met that bare bones expense threshold, you can then build the fund up further to include those other things that are not obligations but things you don’t want to do without in a time of need.
Another alternative is to figure out your circumstance-specific expenses.
Consider the age of your vehicle and how likely repairs will be in the foreseeable future; do some research and make an educated estimate (and round up) as to how much you may need for unexpected repairs.
Then consider your insurance deductible, and throw that in too. Do the same for your home and any possible unexpected situations you might foresee. The total can be your initial emergency fund goal amount.
(And don’t be a smart ass and say you can’t predict the future. I know. But you do know that your 10 year old car is going to need new brakes at some point, and you also know that sometimes the economy goes crazy and layoffs happen, so it’s better to be cautious now when you can afford to be.)
Start small, and start today. Set up an automatic transfer into your savings account and watch it grow.
Personal finance is just that – it’s personal. Maybe emergency funds work for you, maybe they don’t, and maybe you have a different system entirely. The important thing though is that you have some form of contingency planning in case of an emergency.
When you do, the next time the universe throws a flat tire, a roof leak, or a layoff your way, you can impress everyone with how chill you are with your “don’t sweat it” attitude, ‘cause you got cash for that.
Do you have an emergency fund? Where do you keep it?