How to build an emergency fund!
A study by the Canadian Payroll Association in 2017 showed that 47% of Canadians would have difficulties meeting their financial obligations if their pay cheque was delayed by one week. This puts people in a very stressful situation when an unexpected financial obligation comes up. The reality is that those things will come up once in a while. An emergency fund is a way to plan for these events so that they don't catch you by surprise and cause unnecessary stress.
What is an "emergency?"
An emergency is something that comes up that you don't expect but need to address. This includes: car maintenance, home maintenance, broken phone or laptop, or losing your job. All of these will require money and can be very stressful if you're in a tight financial situation.
Vacations, upgrading to the newest iPhone, and Black Friday shopping are not emergencies. Using this money to save up for a large purchase is not an emergency. You want to save money for those things in a separate account.
How much do you need in an emergency fund?
An average emergency fund can range from 3 to 6 months of your expenses. If your monthly expenses are $3000, you want to have anywhere from $9000 to $18,000 in an emergency fund. This is a very large range, and there are a few factors you want to consider to help with narrowing down the right amount. Some of these include:
1. Are you a homeowner or renter? This is important as being a homeowner takes on extra unexpected expenses for maintenance. If your washing machine or sink breaks, you're the one financially responsible to fix it. As a renter, it's your landlord's job to take care of these.
2. Do you own a car? Depending on what type and how old your car is, you will have to set aside money for unexpected car maintenance costs.
3. Do you have job stability? If you're unsure whether you'll be in the same job 6 months from now, you will need a larger emergency fund.
4. Are you self-employed, a business owner, or someone whose income fluctuates? When your income varies, there will sometimes be months when you make less than you expect. Having a larger emergency fund allows you to maintain your lifestyle during those months, instead of reaching into debt.
5. What is your personal preference? Do you prefer more money sitting there handy in case of an emergency? Or do you want to minimize your emergency fund so you can focus on growing your money?
These are just a few things to consider when building your emergency fund. Every person is different and you need to make a decision of how much of a "safety net" you need for your particular situation.
Where do I put the money for an emergency fund?
There are a few options in regard to where to keep the money for the emergency fund. The most common ones are:
1. High interest savings account
2. Laddered GIC
3. Line of Credit
High-interest Savings Account
I usually recommend just keeping the money in a high-interest savings account. I personally keep my money in Tangerine, but you can open up a high-interest savings account in any major banks. I find that online banks (such as Tangerine, Simplii, Manulife) offer higher interest rates.
If you haven't used your TFSA before, you can allow the interest to accumulate in one tax-free. However, the difference is nominal and you would want to use that room for investing instead if you had the choice.
It's important to have a separate account meant just for your emergencies as it avoids the temptation of dipping into your emergency fund for everyday expenses or big purchases. This is why I have a separate online bank, to park my money to grow with higher interest rates, without paying fees.
What some people like to do is have a "laddered GIC." What this means is having a month's expenses handy in a savings account, and having three separate 3-month GIC's. You will issue one the first month, another one on the second month, and the last one on the third month. Once the third month is up, your first GIC matures and you can reinvest it again. You continuously reinvest the GIC's until you have an emergency. In that case, you'll have 4 months' worth of expenses accessible.
It's a smart way to accumulate higher interest than in a savings account. However, I find the excess return you get from using this strategy doesn't outweigh the amount of time and energy you use to implement and maintain it. Use this if you want to maximize your returns on your emergency fund.
Line of Credit
Some people don't like the idea of having $10,000 sitting in a savings account. They look at it as "missed opportunity" that could be used to invest in other things. These people like to rely on a line of credit in case of an emergency.
I would recommend it if you have a higher risk tolerance and if you are comfortable with debt. You also have to consider the interest rates of the line of credit you have. If you have a home equity line of credit (HELOC) or a preferred rate through the bank, it is a cheap form of credit in case of emergencies. If your line of credit has an 11% interest rate, you're better off using a savings account.
For those starting off
For many people just starting their financial life, the idea of putting aside $9000 to $18,000 (or whatever amount it is for you) might seem overwhelming. If you've never saved before or find it hard, it might be daunting and stop you from taking the right actions.
Dave Ramsey had a smart idea of setting yourself up to win. Start with something realistic and achievable first. Set a goal to put aside $1000 and once you've reached it then you can work towards the next progression. This is a great first step to work towards an emergency fund.