Do You Have an Emergency Fund? It's Easier to Set Up Than You Think
Asking people to save up for something that may never happen is understandably a tough sell. So perhaps it’s not surprising that, according to a 2019 BMO poll, just 36% of Canadians who have long-term savings are setting money aside in an emergency fund, and one in four feel the amount in that fund is insufficient.
If you count yourself among this cohort of underprepared Canadians, take heart. There are simple ways to save for a rainy day and boost your emergency savings fund, so you won’t have to incur debt when calamity strikes.
What Is an Emergency Fund?
As the name implies, an emergency or rainy-day fund is money that you save specifically for unexpected financial difficulties. In other words, these savings are off limits to you unless you encounter a genuine emergency, such as:
- a job loss
- property damage, or
- long-term illness
While you might try to convince yourself otherwise, a 75%-off sale is not the type of emergency this fund is intended for. Neither is a vacation, wedding, home purchase, renovation, new car or anything else that’s a non-necessity. Which isn’t to say you shouldn’t save up for those things if you want them. You absolutely should! Just do so in separate accounts intended for those specific purposes, and start those savings goals after you’ve established your emergency fund. Same goes for your retirement savings fund.
Why It’s Important to Have an Emergency Fund
Nobody knows what the future holds but, as Murphy predicts, anything that can go wrong will go wrong. And, when it does, it usually costs money to fix. If you don’t have a cushion of savings to rely on when the basement floods, or your car needs repairs, how will you pay for these added costs in addition to all your usual monthly expenses?
Even worse, if you can’t work due to a layoff or disability, how will you even cover those basic expenses, such as the rent or mortgage, food and utilities? A loan may be impossible to obtain when you can’t work or are in other financial straits, because lenders consider you a bad risk. Your only option may be to rack up credit card debt at a high rate of interest that can be very costly and difficult to dig out of.
How Much to Save in an Emergency Fund
Deciding how much to save for emergency purposes depends in part on your monthly expenses, your work, and how much (and the type of) debt you have.
- Expenses: If your monthly expenses are quite low—say, if you’ve paid off your mortgage or are living rent-free with your parents—you might not need a very big emergency fund. That’s because you’ll want to save enough to cover at least three-months’ (and up to a years’) worth of expenses if you can’t work.
- Type of work: Some people work in fields or positions that are in demand and may not have much difficulty finding a new job at a similar income if they got laid off. Others, however, might be in a field with more available workers than jobs. They would be wise to plan for a longer stint of unemployment and, therefore, accumulate a larger emergency fund.
- Debt: Those who are carrying a lot of high-interest debt, such as credit card debt, might be better served by paying down that debt before accumulating savings in an emergency fund. In that case, however, as soon as the debt is paid off, the money that went toward servicing and paying down debt can be channelled into an emergency fund
Using an Emergency Fund Calculator
If you want to be sure you’ll have enough set aside for the worst-case scenario—losing your primary source of income—you could use an emergency fund calculator to crunch the numbers for you.
Here’s the information you’ll need to use the calculator:
- Average Monthly Expenses: This is the amount you must pay every month for necessities, such as housing, food, transportation, utilities, property taxes and interest payments on debt, as well as other expenditures that you cannot easily cut out from your budget, such as school tuition, daycare or union dues.
- Existing Liquid Savings (excluding retirement): This is any sum you’ve already saved up that’s easily accessible. Do not include any money in a Registered Retirement Savings Plan, Registered Education Savings Plan, or other long-term investments.
- Ease of income replacement: As discussed above, depending on the type of work you are qualified for, you may have an easier or harder time finding a new job with similar pay.
Once you key in those values, the calculator will determine the following:
- Possible length of unemployment: This is the number of months it might take you to find a new job with similar pay.
- Amount required to cover this period: This is your total expenses over the time of potential unemployment (or the Possible Length multiplied by the Average Monthly Expenses).
- Amount you need to save: This is how much more you must save in your emergency fund, once you’ve accounted for any sum you’ve already socked away (or Amount Required minus Existing Liquid Savings).
Where to Put an Emergency Fund
Since the nature of an emergency means you likely won’t have any warning before it happens, the money in your rainy-day fund must be easy to access at a moment’s notice. That means it cannot be tied up in any kind of investment that carries risk, because you can’t know what the state of the market will be in when you need to withdraw the funds. If the investment experiences a loss in value right before you need the money, you could be out a bundle.
On the other hand, you don’t want to leave your emergency fund in a traditional chequing or savings account, because you’ll earn little to no interest.
Here are three better options for where to keep your emergency fund:
- High-interest savings accounts. A number of financial institutions in Canada offer specialized savings accounts that pay out higher levels of interest without exorbitant fees for infrequent withdrawals.
- Guaranteed Investment Certificates (GICs). Also called term deposits, GICs offer higher interest rates than savings accounts, so long as you leave your money invested in the GIC for its entire term. Because you may need access to your emergency funds quickly, go for a shorter term (of 30 or 60 days) that you can roll over when the term ends. If you do choose to invest in GICs, keep at least 30 or 60 days’ worth of savings in a high-interest savings account to tap into first, so you won’t need to withdraw money from the GIC early.
- Tax-free savings accounts (TFSAs). A TFSA is like a bucket where you can put savings or investment accounts and shelter the earnings from tax. Your savings will earn interest tax-free, meaning you won’t have to pay any income tax on the interest income, as you would with a non-registered account. Just make sure to stick to low-risk investments, such as GICs or high-interest savings accounts, within your TFSA since you may need to cash out quickly.
How to Build an Emergency Fund
As any personal financial planning expert will tell you, the best way to save money is to pay yourself first. What this means is that as soon as you receive your paycheque, you take a predetermined amount off the top and deposit in into your emergency fund account. You can even set up automated transfers to simplify matters.
But, how will you know much you can you afford to transfer into savings? For this, you need to create a budget so you can see exactly where your money is going. Look at how much you are spending on needs (housing, groceries, transportation, etc.) and how much on wants (entertainment, vacations, eating out, etc.) to see where you might be able to cut back so you can transfer more to your emergency fund, or pay off debt, if necessary.
As previously mentioned, if you are in debt, getting out of debt should be the priority for you. Once you’ve paid off your debt, redirect those monthly payments to the emergency fund.
Finally, if you feel you cannot possibly cut out any expenditures from your budget in order to save more, you can try to increase your income through a side hustle, selling items you no longer use, or asking your boss for a raise.