Preparing for an emergency is never fun. Not only do you have to consider the possibility of a painful future, but then you have to put today’s fun on hold to help with tomorrow’s (possible) pains.
Despite that, preparing for emergencies remains an essential part of creating a robust financial plan. It creates a bridge over troubled water that helps us navigate the most difficult times in our lives, making future success more likely.
That’s why we always urge our clients to set aside an emergency fund.
It’s very simple to do. With just a bit of consideration and automated savings, you can ensure your financial plan is solid enough to deal with anything life throws at you.
What is an emergency fund?
Before we get into the how and the why, we’ll quickly define what an emergency fund is and how much you should think about putting aside.
The simple definition of an emergency fund is savings you’ve put away to help ease any unexpected situations that need to be dealt with as soon as possible.
This can include:
- Health/ dental procedures that are not covered by universal healthcare
- Vehicle accidents that are not fully covered by insurance
- Major, urgent repairs to your home
- Job loss
The two most important aspects of an emergency fund
Because this fund is meant for emergencies, it should be:
- Easily and quickly accessible – when you’re dealing with an emergency, time is of the essence, so it’s important that the fund can be accessed immediately and without penalty.
- Separated from your daily funds – by separating your emergency fund, you make sure that your normal, everyday expenses don’t accidentally dip into the money you’ve earmarked for emergencies.
How much you should save in an emergency fund
To ensure the fund covers you and your family, we recommend having an emergency fund that covers 3-6 months of ordinary expenses.
Why do I need an emergency fund?
Life is never as neat as we would like it.
We create all types of plans, like saving for retirement, put away money in RESPs for our children, and even going on that trip to Europe. But, when the unforeseen happens, what was easily possible yesterday becomes a stretch, or even impossible today.
Then your carefully constructed plan is scrapped so you can deal with the sudden, unexpected costs that require your attention right now.
An emergency fund allows you to pay these major, unforeseen bills without ruining your financial and life goals.
What could happen without an emergency fund?
One of the first things that happens in an emergency we’re unprepared for is the little luxuries of living, like vacations or Christmas gifts, go out the window.
If that doesn’t offer enough savings, we often dig into savings accounts, like RRSPs.
Once we get to that point, we end up taking on penalties by pulling out savings early, or are forced to wait to deal with the emergency while assets are moved around.
If we can’t wait, or access savings, we start to access debt. We put it on our credit card, line of credit or pull a payday loan. This increases the cost of the emergency in line with the interest (which can be up to 442% for a payday loan), along with the length of time we are paying it back for.
How to build the best emergency fund in three steps
- Budget for it – The best way to create a robust emergency fund is to work it into the budget. First, find out how much your budget is for a month. This dictates how much you need in your emergency fund (3-6 months' worth of expenses). Then, figure out how much you can put away, outside of your current savings, into the fund.
- Set up the right account – If you leave your money in your chequing account, it is much easier to access by accident, and it recedes in value due to inflation. Instead, we recommend opening a TFSA or a high-interest savings account to make sure your funds continue to grow.
- Automate payments – By automating the payments to the account you opened, you take a lot of the friction out of saving and ensure it gets done every month. This makes saving painless
How much should I have in an emergency fund?
For most people, we recommend maintaining at least three months’ worth of expenses in your emergency fund. However, for small business owners, we typically recommend 6 months’ worth of expenses.
What qualifies as an emergency?
Our typical rule of thumb is to ask yourself the following questions:
- Is it unexpected?
- Is it necessary?
- Is it urgent?
Emergencies can include:
- Medical, dental or veterinary emergencies (or anything that threatens a life.
- Accidents, car repairs or other insurance deductibles to necessities
- Unexpected job loss (or a down month for business owners)
What doesn’t qualify as an emergency?
If you can’t answer yes to all three of the questions in the answer above, chances are it’s not an emergency. For example, a baby, a car payment or a down payment on a home do not meet the standard.
Where should I keep my emergency fund?
We recommend keeping your emergency fund in a TFSA or a high-interest savings fund to avoid losing buying power through inflation.