What is an emergency fund?
An emergency fund is money that is available to meet unexpected expenses. You may be managing your current budget, but life tends to throw curveballs. Emergencies like a job loss or illness can lead to a reduction in income. Unanticipated expenses like a car repair, house repair or a trip to the dentist put sudden demands on your finances. An emergency fund helps you pay for these unplanned costs.
Why is an emergency fund necessary?
The number one reason to have an emergency fund is to help you avoid unnecessary debt. Having a rainy-day fund helps you pay for these unplanned costs without using credit card debt, or worse taking out a payday loan.
Having an emergency fund provides several benefits:
- You avoid accumulating unwanted debt.
- You’re not forced to forgo needed items or postpone a bill payment when a financial emergency arises.
- You have less stress and confidence that you can weather a short term financial crisis without creating new money worries.
- You avoid any possible negative impacts on your credit report due to high borrowing or missed payments.
How much should you save for an emergency?
Many people wonder how many months savings they need in an emergency fund. Most experts agree you need to be able to weather at least 3 to 6 months worth of expenses in the event of a job loss. However how much you need is a very personal decision.
You will need a bigger emergency fund if your income is not secure. If you might lose your job or expect your hours to be reduced then it’s even more important to have a larger emergency fund that will cover rent, food, utilities and living expenses while you look for work.
If you are more worried about unexpected expenses popping up, then having a backup fund of at least $1,000 is a good start.
You don’t need worry that you must set aside your full emergency fund right away. If your goal is to have $1,000 saved, then you will need to set aside $20 a week to build your reserve fund within one year.
Where should you keep your emergency funds?
Your emergency fund should meet two key criteria:
- It should be readily available cash that you can access easily
- It should be invested in an account that is safe from market risk
It also makes sense to seek out a good interest rate however this is not a primary concern. Your emergency fund is not investment savings, it’s a reserve fund for just that – emergencies.
Having your emergency fund at a bank in a saving account that is accessible by your debit card is the simplest approach. A savings account (rather than a chequing account) will earn you a bit more in interest but access via your debit card ensures that you can get to the money when you need it.
If your reserve is larger, say you have 6 months worth of savings, you might want to put a portion of your money into a cashable money market fund. Make sure there are no costs to closing the fund in the event you need to convert the fund to cash.
Can I use a line of credit for emergencies?
Yes, a line of credit or other available credit is an option for meeting emergency expenses but using debt for an emergency fund comes with some risks. The advantage of a line of credit is that you have access to pre-approved credit for when you need money fast.
There are, however, some downsides to using credit as a form of emergency fund:
- You will pay interest on your borrowings until you can repay the amount your borrowed in full.
- You may be tempted to use your line of credit for non-emergency purchases.
- You may incur more debt than you can repay, adding to your financial problems down the road.
How to easily build an emergency fund
The best way to build an emergency fund is to have a plan. Creating a goal and sticking to it will make it easy to meet your savings target. Here are 6 tips to help you build your emergency savings:
- Review your budget for savings and transfer this amount to your emergency savings. Every little bit helps. Once you have your emergency fund built up, you can feel free to put this back into everyday spending (or apply it to other savings goals)
- Automate your savings through online banking and you are much more likely to achieve that goal than if you rely on your memory or personal discipline.
- Sell off extra or unwanted assets. Most of us have stuff filing up our closets or basements that we don’t use anymore. Have a yard sale or put some items up on Kijiji.
- Take on a temporary part time job. If you are worried that you might hit a snag sooner than later, then take on some extra work, even temporarily to build up some extra cash.
- Only use your emergency fund for emergencies. Once you start building your fund, don’t be tempted to dip into that fund for non-emergencies.
- Set up a separate savings account helps you monitor your progress and ensures you protect these funds from being depleted for everyday expenses.
Avoid these common ways to pay for emergencies.
The purpose behind an emergency fund is to avoid using expensive debt or cashing in long term savings when you need money quickly.
Be careful using your credit cards. A cash advance may provide you with quick money but it’s an expensive borrowing option. Avoid using your credit cards for emergency funds if you can’t pay off your balance in full. If you bump up against your credit limit, or worse go over your credit limit, and can’t pay off the balance you will also see a negative impact on your credit score which can impact your other borrowing options long term.
Try not to drain your retirement savings. Withdrawing money from your retirement account comes at a cost. When you initially put the money into an RRSP, you received a tax deduction. Withdrawing the funds will mean you will have to pay tax on the amount withdrawn. Most institutions will holdback at least 10% of your withdrawal for applicable taxes, which means you will need to take out even more than the amount you need to cover your emergency.
Avoid payday loans and other quick money loans. It may be easy to walk into a payday loan store or apply for a quick loan online however these are very expensive borrowing options. If you use a payday loan, not only is the interest rate high but you will have to pay back that money our of your next paycheque creating a possible cash shortfall cycle that is hard to break.
If you don’t have enough set aside to cover your emergency consider asking friends & family for a temporary loan, selling off some assets or even asking for extra time to pay.
Having an appropriate emergency fund should be part of your overall financial strategy. Many of our clients find that once they have eliminated excessive debt they have the cash-flow they need to begin the process of building an emergency fund as part of their fresh start.