We’ve all seen scenes like the image above on the news. An improperly cleaned lint trap leads to a home going up in smoke. Or perhaps it’s an unattended candle or old wiring. A small, seemingly insignificant mistake that lands a family in an emergency situation.
If you’ve thought to yourself “that won’t happen to me” you’re probably right. Your house probably won’t burn down anytime soon, but odds are you will face a financial emergency in the future. Whether its job loss, a car accident, illness or even a death in the family, emergencies both large and small happen every day.
Are you ready for one?
Most Canadians aren’t. According to the Rainy Day Survey conducted by Pollara, 24% of Canadians live paycheque to paycheque. Another survey from the Bank of Montreal reveals that 21% of Canadians have less than $1,000 saved, and 44% have less than $5,000 set aside for emergencies.
In all of the situations listed above, financial hardship can be avoided by setting aside cash specifically for emergency situations. This cash is commonly called an emergency fund, and you should have one.
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What is an emergency fund?
An emergency fund is an amount of cash that serves no other purpose than to protect you in case of an emergency. It’s not for buying a home, renovating, taking a vacation, upgrading your vehicle or even paying off debt. An emergency fund just sits, untouched, until you are faced with an emergency situation. Then this fund is there for you.
How big should your emergency fund be?
There are several schools of thought on how large an emergency fund should be, but the consensus is that if you are in debt, you should pull together a small emergency fund of between $2,000 and $5,000. This emergency fund will cover minor emergencies like car repairs, visits to the veterinarian or home repairs. A small emergency fund will suffice while you pay off your debt because your dollars can be better spend eliminating high-interest debt like credit card debt or car loans.
That being said, it depends on the type of debt you have. If you’re sitting on huge credit card debt, it probably makes sense to pay down that first before building your emergency fund. Now, if you have low interest debt such as a student or car loan, saving for your emergency fund still makes sense.
Once you become debt free, your emergency fund should be larger. A general rule of thumb is that your emergency fund should cover between three and six months of minimum living expenses. For example, if your monthly budget allots $4,000 per month in expenses, but $1,000 of those expenses are variable or not essential, your minimum expenses would be $3,000. Therefore, your emergency fund should be between $9,000 and $18,000. This is enough money to handle the more catastrophic emergencies like critical illness, extended job loss, or major home repairs.
Where to keep your emergency fund
With thousands of dollars on the line, you should consider keeping your emergency fund someplace other than a standard chequing or savings account. If you go this route, you’ll forgo hundreds of dollars annually in earned interest, and the value of your emergency fund will erode slowly erode as fees take their toll.
Instead, consider moving your emergency fund to a high-interest savings account, or even a Tax-Free Savings Account. Both options will allow your cash to earn interest while giving you security against emergencies.
For example, let’s say you have a $10,000 emergency fund. If you opened an EQ Bank Savings Plus Account, you would enjoy 2.30% interest on your money. Over a year that adds up to $230 in interest. In contrast, the Bank of Montreal Premium Rate Savings Account offers just a 0.05% interest.
If you plan to save even more money and you are concerned about paying taxes on the interest you earn, you could also consider growing your emergency fund within a Tax-Free Savings Account. If you choose this route, you’ll still have access to the favourable interest rates of a high-interest savings account, but your money will grow tax-free. Just make sure that if you don’t over-contribute and that you keep track of your withdrawals and contributions to avoid penalties.
How to build your emergency fund
If you’ve never saved money before, building an emergency fund may seem daunting, but in fact, it’s a great place to begin mastering the art of saving money. If you have debt, you’ll want to focus on building a small emergency fund. Start by budgeting and finding $100 – $200 in your budget per month to deposit into your savings account. Set up an automatic contribution on pay day, so you don’t even have to think about it. Whenever you have more room in your budget, for example, if you receive a raise or you save money on expenses, take that opportunity to increase your contributions. The momentum will snowball, and before you know it, you’ll have a tidy sum tucked away.
Once you become debt free, use the money you were sending towards debt payments to grow a fully fledged emergency fund. The temptation to spend that money will be strong, but by saving it instead, you’ll set yourself up for a solid financial future.
When to use your emergency fund
Once you have an emergency fund, hanging on to it can be difficult. The saying goes:
If all you have is a hammer, everything looks like a nail.
The same is true for your emergency fund. Once you have money in the bank, every spending opportunity may present itself as an emergency. In truth, you should rarely need to access your emergency fund. Here is a good litmus test for whether the situation at hand is a true emergency or not:
If no, move on to the next question:
- Can I cover this cost by strictly budgeting for a few weeks?
- Do I need to incur this cost to keep myself, my house, my job, or my loved ones safe?
- Is there any other way I could pay for this?
If you answered no to those three questions, the situation at hand is probably a true emergency. Here are some examples of real emergencies, and situations that may seem like emergencies, but aren’t.
- Job loss
- A flooded basement
- A car crash
- Car repairs over $500
- Pet surgery
- Severe illness
Not real emergencies:
- An amazing, once in a lifetime sale on home appliances or electronics
- A minor appliance repair (for example a broken dishwasher or microwave)
- A vacation
- New clothes for a job interview
- Minor illness
Ultimately, whether you decide to pull money from your emergency fund is your decision. The important thing is that you build up your emergency fund to protect yourself from the unexpected. Whether you have $2,000 or $12,000 saved; it’s important to have some money set aside for emergencies.