You should keep at least 3 months’ worth of expenses in an emergency fund to cover unexpected major expenses such as layoffs, healthcare bills and household repairs. Once you’ve saved this amount, you should begin working towards saving 12-months worth of expenses.
What is an emergency fund?
It is a pool of money set aside to take care of unexpected expenses. A financial plan is incomplete without an emergency fund.
These readily available funds help manage financial break-points, such as severe illness, job loss, unexpected home or car repairs, etc. An emergency fund is a safety net of cash or highly liquid assets that promote financial security by taking care of emergency expenses as well as preventing you from needing to draw from high-interest debt options like credit cards and payday loans or even future security options like retirement funds.
Despite the importance and value of an emergency fund, a Canadian poll revealed that 26% of Canadians have no emergency savings, with another 20% having less than 3 months savings and only 21% having between 4-6 months in savings.
You can consider an emergency fund to be one of the best forms of insurance for unexpected expenses – you purchase it from yourself by paying monthly premiums into a special account that you never withdraw from (except in true financial emergency situations). When the money is needed, you also don’t need anyone’s approval to access it!
Top reasons to grow your emergency fund
Having a financial plan helps alleviate the stress of dealing with unexpected expenses and keeps you on track with your financial goals.
Here’s a breakdown of ways an emergency fund would be useful:
Job Loss: No longer receiving a paycheck? Unemployment is the top-cited reason for having an emergency fund, and with good reason too. Living expenses don’t stop because you’re no longer working, and this is why building an emergency fund is vital. Keep in mind that in 2019, unemployed Canadians had to search for work for an average of 16.7 weeks before gaining employment. While EI (employment insurance) can help, it takes time to apply and it’s often not enough to cover all your expenses.
Healthcare: There are many things not covered by health insurance, and even then there are deductibles and copays you have to consider. For example, getting a dental implant could cost up to $2,500 and emergency veterinary visits can cost as much as $10,000. Some hospitals even require upfront payments or deposits. An emergency fund can protect you from having to worry about finances in the midst of a crisis.
Household repairs: A broken air conditioner, leaking roof, flooded basement, plumbing problems – these can all occur out of nowhere and cost tens of thousands to repair. Even with insurance, it can take a while to apply and get approved, and you need to get things fixed before things get even worse in the meantime. If you’re a homeowner, you need an emergency fund to handle costs like this and make owning your home less stressful.
Less Reliance on Credit Cards: Credit card debt can be overwhelming, as you have to consider interest charges, overdraft fees and the effect of late payments on your credit score. All of these make relying on credit cards for emergencies unwise. It’s easy to get into a debt spiral if you don’t have an emergency fund.
How much should I save in my emergency fund?
It’s impractical to give exact figures on how much should be stashed in your emergency fund, but experts recommend that your cash reserve should cover three to six months’ living expenses.
In 2017, the average annual expenditure in Canadian households was over $86,000 (approximately $7,000 monthly). If you spend the average amount every month, the minimum amount in your emergency fund should be about $21,000 to cover for 3 months’ worth of expenditure.
After meeting your 3-month goal, the next step in building a solid emergency fund is to save up to 6 months’ worth of expenses so you can deal with much bigger financial issues such as a job loss or a major house repair. If you are ever in a situation where you’re unable to go to work, for instance, an emergency fund allows you to take the time to find a new job or source of income. If your household spends up to $7,000 in monthly expenses, a 6-month emergency fund would be about $42,000.
Your emergency fund will be a strong safety net if you build it high enough to cater for up to 12 months’ expenses and at $7,000 monthly, which amounts to $84,000. This is a lot of money, but in a dual-income household, both partners can contribute. You can also treat it as savings for a down-payment.
How can I save enough money for my emergency fund?
The most important qualities in successfully saving for your emergency fund is planning and consistency. Here are some tips to consider:
- Set a monthly savings goal – transfer a fixed amount into your savings account each time you get paid. The key is to be consistent, even if it’s only $50 you plan to save every month.
- Save your tax refund – if you get a tax refund, consider adding it to your emergency stash. You could arrange for the refund to be directly deposited into your emergency savings account.
- Cut down your expenses – which part of your expenses can be trimmed so you have some leftover cash to build your emergency fund? You could consider eating at home more often and carpooling to save costs on food and transportation.
- Get a second job – if you are simply unable to save money from your current expenses, getting a second job might be the only way to save the money required to build your emergency fund.
Where should I store my emergency fund?
The two most important factors when choosing an emergency fund are the safety and liquidity of the account.
Your emergency fund should be kept in something that is low to no-risk, such as a high-interest savings account because you want this pool of money to be safe and extremely liquid. In other words, you can access the money whenever it is needed.
Understanding the safety and liquidity of different options
When setting money aside for your emergency fund, you want to be able to readily access the fund when you need it without a withdrawal penalty.
Should you invest your emergency fund in the stock market? Most financial professionals don’t recommend doing so because stocks are volatile and you could easily lose a significant amount in a short period of time. In addition, during a recession, your need for funds is likely to go up while the value of your savings in stocks will go down. While bonds are not as volatile as stocks, they still have some degree of volatility and as such, are also not recommended as a safe/liquid option to stack your emergency funds.
You might be considering keeping your money in a typical chequing or savings account. However, when interest rates are very low, you would earn little to no interest on your money. Additionally, you’d be losing value with an inflation rate of 2-3%. Hence, the best option would be somewhere that earns about 2-3% interest so as to counter the effect of inflation.
Money market funds are widely acclaimed to be safe and liquid, so parking your funds in them is a good way to build your emergency fund. Although money market funds are considered one of the safest investment vehicles, some of them are not insured by the CDIC (Canadian Deposit Insurance Corporation), so be sure to check for that. Also, some banks offer debit cards in their money market fund packages so you can gain instant access to your funds.
Another option that ticks both boxes of safety and liquidity is a high-interest savings account. You can put your money here if you trust yourself enough to not take out your emergency fund to service needs that aren’t dire emergencies. Usually, this account comes with a debit card, so you can access your funds either via an ATM or by walking into the bank.
When can I take money out of my emergency fund?
Before taking money out of your emergency fund, ask yourself whether or not you’re facing a real emergency or cash flow problem.
In actual emergencies, do not hesitate to use your emergency fund. It’s what it’s there for, and will be a much better option than borrowing money. However, if you realize that you aren’t facing an urgent need, don’t touch your emergency fund. It’s easy to get tempted to spend your savings away, and you need to make sure to leave it for a real emergency.
Keeping an emergency fund is an excellent way to improve your financial health. Since our finances directly affect our physical health, it’ll help to reduce your stress and improve your health and wellbeing. Take note of the safety and liquidity of any option you choose to keep your emergency fund in, and only make withdrawals when necessary.