What is an emergency fund?

by Ratehub.ca April 7, 2020 / No Comments

Life is unpredictable, and everyone in Canada is experiencing that truth first hand these days. Things tend to change regularly, often having an impact on a person’s finances. That said, there’s no wrong time to start thinking about building an emergency fund.

An emergency fund is a fundamental component of personal finance and a surefire way of stabilizing your financial future.

There’s no definite blueprint on how to build an emergency fund, but there are some universal techniques and approaches to saving that can make your journey to creating one more effective.

Check out the Ratehub.ca guide to COVID-19 – Personal finance during COVID-19

Emergency fund: a definition

An emergency fund is a sum of money set aside for an unforeseen financial expense. It acts as a financial safety net in the face of a costly emergency.
Some of these unexpected expenses can include or be a result of:

  • An unexpected loss of employment,
  • A significant home repair (such as flooding or exterior house damages),
  • A sudden illness or related medical expenses, or
  • Major car repairs.

Having a stable emergency fund can help make financial disruptions like the ones listed above more fiscally manageable.

Lack of an emergency fund can extend the impact of the sudden expense, which can be a significant stressor for you and your finances.

Why should you have an emergency fund?

Since an emergency fund acts as a financial safety net, having one helps lessen the strain of an unforeseeable expense.

It also helps Canadians avoid accruing high-interest debt from credit cards, loans, or payday loans.

Finally, an emergency fund can help you avoid dipping into your long-term savings or retirement fund, which can be highly taxed.

How much should you keep in an emergency fund?

The purpose of an emergency fund is meant to cover your most basic monthly expenses in the event of job loss. Other emergencies, such as home repairs or car repairs, for example, are a little harder to prepare an exact amount for.

Having six months of living expenses covers e

For example, in the instance of an unexpected job loss, an emergency fund should cover three to six months of costs, such as rent or mortgage payments, child care, car payments, groceries, or other unavoidable expenses.

The nature of the beast is, the more you place in an emergency fund, the bigger your safety net is.

How to build an emergency fund

Building an emergency fund requires a few preliminary steps, which align with knowing how to save effectively.

This usually begins by creating a budget and followed by allocating a set amount of money each paycheque towards a savings account.

An emergency fund, however, requires a different planning strategy than other savings goals, such as retirement planning.

Here are steps that can help you effectively build an emergency fund.

1. Calculate your expenses for 3 to 6 months

If you’re wondering how much money you should contribute to an emergency fund, a general rule for hovers around 3 to 6 months of living expenses. These living expenses should be the most necessary and unavoidable expenses, such as:

  • Rent or mortgage payments
  • Car payments and gas
  • Bills and utilities
  • Groceries
  • Child care

While the monthly costs listed above are tailored towards loss of employment, an emergency fund of this size should cover other emergency expenses as well.

Remember: an emergency fund is supposed to keep you afloat during times of financial hardship, meaning keep you or your loved ones financially stable.

Additionally, aspects to consider along with your monthly expenses include credit card payments, student loan payments, and additional bills.

2. Revise your monthly budget 

While this step seems rudimentary, revising your monthly budget is crucial in understanding how much you can exactly allocate towards an emergency fund each month.

By revising your monthly expenses, you’ll be able to create a monthly saving goal and measure your progress.

3. Set up a designated savings account and monthly savings goal

A designated account for an emergency fund makes it easier to track your progress while lessening the temptation to spend your savings.

There are times that many people find themselves dipping into their emergency fund. Separating your expenses allows you to maintain and track your progress with ease.

Where should you keep an emergency fund?

Since emergencies are unpredictable, your emergency fund should be easily accessible at a moment’s notice. That means being able to withdraw your funds instantly.

Ideally, there are two types of accounts that can hold an emergency fund: a Tax-Free Savings Account (TFSA) or a High-Interest Savings Account (HISA).

Tax-Free Savings Account (TFSA)

Whether you use a Tax-Free Savings Account or a High-Interest Savings Account, these two accounts are generally the best options for an emergency fund. However, knowing how each account works is the first step in building an emergency fund.

  • A Tax-Free Savings Account is an account that allows your savings to grow tax-free. While a TFSA can hold various types of investments as well, savings held in a TFSA enables your money to be withdrawn quickly and, depending on the financial institution, instantly.
  • A Tax-Free Savings Account is ideal for an emergency fund because it allows you to make penalty-free withdrawals. There is a slight downside, however. As a registered savings account, Tax-Free Savings Accounts come with a yearly contribution limit, meaning that withdrawals deduct from your yearly contribution room. Unused room from your TFSA carries forward each year.

High-Interest Savings Account

  • Using a High-Interest Savings Account for your emergency fund savings is also an ideal option because high-interest savings accounts offer access to your funds at any moment. They also are non-registered accounts, meaning that they do not have contribution limits. The downside is that interest earned on your funds is taxable at the same rate as your income.
  • In both cases, you should find an account with no monthly fees and an interest rate of 2.00% or higher. This allows you to keep more money towards an emergency fund and earn an interest return that matches Canada’s inflation rate.

Accounts or investments you shouldn’t use for an emergency fund

Certain types of saving and investing accounts are designed for parking your money over long periods, which means they can come with certain penalties for withdrawals. In some cases, the accounts do not even permit withdrawals. It’s important to distinguish that these accounts aren’t ideal as you would not be able to withdraw your money should you require access to these funds.

  • A Registered Retirement Savings Plan (RRSP) is much more versatile than people give the account credit. RRSPs can hold cash savings, along with various types of investments. Using an RRSP is a crucial tool for retirement saving, but placing your emergency fund in an RRSP isn’t an ideal place for it. This is due to the RRSP withdrawal tax-rate, which is quite high, depending on the amount you’re withdrawing.
  • Guaranteed Investment Certificates (GICs) are term deposits that do not allow withdrawals. Term deposits, such as GICs, are investments that come with a fixed term. Usually, depending on the GIC, your investment is not returned to you until the GIC’s term is complete, thus making it an excellent investment for long term saving but an unsuitable one for an unpredictable emergency.
  • Other investments such as mutual funds, exchange-traded funds (ETFs), and stocks are suitable options for long-term investing, but not ideal for emergencies. If your investments are in decline, you can lose money by selling if they’re down or miss out on opportunities if the value of your investments increases. You should certainly consider investing, but having an emergency fund should come first.

Should you build an emergency fund or pay down debt?

There are different answers to whether you should build an emergency savings account or pay down debts. Ideally, you should pay off high-interest (also known as revolving debt) first. These debts include loans and credit card debts first and exceptionally high-interest debts such as payday loans.

If you have low-interest loans, such as student loans or a mortgage, you can build an emergency fund while making regular payments on those debts.

Since these debts come at a higher interest rate, it’s best to pay those down as quickly as possible, while budgeting what you can save, too.

The bottom line

Saving isn’t easy, though it shouldn’t be complicated. While every person has a unique financial situation and priorities, gaining control and perspective of your finances always begins by creating a bi-weekly or monthly budget and living beneath your means. Taking these steps first is the only way someone can start contributing to an emergency savings account.

By following the steps outlined in this article, you should find yourself with a small fortune within a year. That said, building an account with a substantial amount takes time and patience as well. Remember, this is a journey and not a race!

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