Red Alert: What is an Emergency Fund & Why Do I Need One?
Do you need an emergency fund? When times are good, it’s tempting to put your money elsewhere: whether it’s spending on a night out, those new Bluetooth speakers, or even beefing up your long-term investments.
The problem is that at some point, something is bound to come up that you didn’t plan for. You don’t plan for a layoff, or a mid-career crisis. You don’t plan for your basement to flood, or for your car’s timing belt to blow. And you certainly don’t plan to have these things happen all at once. But sometimes they do. (And all of us have learned just how sudden things can change in the midst of the 2020 pandemic.)
That’s why it’s essential to have an emergency fund.
An emergency fund is the foundation of financial health. So, if you’re in a position to save money, building up those rainy-day savings should be your first priority.
One word of caution: if you have high-interest debt, you should work to pay that down first before saving for emergencies.
Not sure where to start or how much you’ll need to save? We’ve got you covered.
In this article, we’ll explain
- What an emergency fund is and why you need one
- How much you should save for emergencies
- How to build your emergency fund
- Where to keep your emergency savings
Let’s start from the top.
What is an emergency fund and why do I need it?
An emergency fund is a stash that you keep aside in case of unexpected expenses or loss of income. Emergencies are a fact of life, so you can expect that at some point, these savings will become your financial lifeline.
Benefits of an emergency fund
Building up emergency savings takes discipline, but there are so many good reasons to do so. Here are the benefits of an emergency fund:
1. Reduce financial stress
An emergency fund gives you the peace of mind that if a crisis hits, you can still cover life’s essentials. Whether it’s paying rent, or buying winter boots for your kid, having emergency savings will give you the confidence that you can meet your obligations, so you don’t lose sleep over how you’ll pay the bills.
2. Avoid costly debt
Turning to high-interest debt (such as credit cards or some personal loans) in a crisis can be devastating to your financial well-being. As your debt piles up, so does the interest expense. That interest can snowball and you can find yourself struggling to get free from that debt long after the initial emergency has passed. By saving the money upfront you can avoid that situation.
3. Avoid dipping into retirement savings
Your RRSP is there to help you save for retirement, it’s not an emergency fund. If you dip into it in a pinch, you’ll be hit with a withholding tax upfront, and may even end up paying additional income taxes. Plus, early withdrawals can cost you years of potential investment growth.
How much should I save for emergencies?
As with any financial planning, it depends. As a starting point, assume that you should save enough to cover about 6 months of living expenses. But the more obligations you have (pets, kids, mortgage, car costs, loan payments), the more you’ll need to save. Meanwhile, if you have fewer obligations, you may be able to take a calculated risk of keeping less in emergency savings.
Below, we’ll help you walk through the specific things you need to take into account to find your magic number. Keep in mind that because you can’t predict what kind of emergencies will come up, this number is always going to be an estimate.
Calculate your emergency fund
To calculate how much you’ll need in emergency savings, start by adding up your monthly expenses.
It’s a good idea to calculate your expenses as a range where the higher end reflects what you’d need if you want to be able to maintain a fairly consistent lifestyle, and the lower end reflects the minimum amount you would need in order to cover the basic necessities. You can omit any expenses that you’d be readily willing to part with in a pinch (such as streaming services, takeout, and entertainment expenses) from the bottom range.
In order of priority, your critical expenses should include:
|Housing (rent or mortgage payments)||If you lost your job and would want to stay in your house, you should be prepared to cover theses expenses in full. Don’t forget to include things such as property tax.|
If you could realistically move into a less expensive place, then you can factor those savings into your minimum range.
|Groceries||You’ll need to feed yourself. When calculating your range, start with what you’re spending now, and then consider whether you’d be able to reduce your grocery bills in an emergency.|
|Utility bills||Assume you’ll need to continue paying for any utilities that you currently cover such as heat and hydro.|
|Phone and internet||If there’s any opportunity to reduce these expenses, you can factor that into your calculations.|
|Transportation (car or public transit expenses)||If you have a car, would you keep it in an emergency? Consider whether you’d be able to save on expenses such as parking, or gas, if your lifestyle were to change.|
|Insurance||Just like emergency savings, insurance can be a lifeline. Ideally, you’ll continue contributing to costs such as home, health, or life insurance in an emergency. |
You might be able to cut down on something like car insurance if you’re not working.
|Other recurring expenses||Comb through your bank statements and credit cards to find any other regular costs. Consider whether you’d need to cover these in an emergency. |
If you have debt payments such as a line of credit or student loan, you’ll want to include these.
If you’re a parent, these costs might include things like your kid’s clothing or extra-curriculars.
Here’s an example of what calculating that range could look like.
The current costs represent the amount required to continue paying for your lifestyle (minus a few easy-to-part with expenses), while the minimum costs represent a less expensive, but still feasible, lifestyle.
|Expense||Current monthly spend||Ways to save||Potential savings||Minimum monthly spend|
|Housing||$2,100||Move in with a roommate||$800||$1,300|
|Groceries||$290||Eat less prepared foods||$90||$200|
|Phone & internet||$150||$0||$150|
|Transportation||$605||Reduce parking costs, minimal gas expenses||$125||$480|
|Other||$750 (student loans, online courses, entertainment)||Cancel online classes, cut entertainment budget.||$600||$150|
Once you know your monthly expenses, multiply that by the number of months you intend to save for. Here’s a handy chart of the factors you should consider when deciding how many months worth of emergency savings you’ll need.
|Start small (3-6 months)||Increase savings (6-12 months)|
|Age||The younger you are, the fewer expenses or financial obligations you’re likely to have.||As you age, you’re likely to have more expenses (such as house and car payments, medical expenses, debt payments).|
|Profession||If you work in an in-demand profession, you may be able to recover from unemployment sooner.||If you work in a volatile or seasonal industry, expect that it will take some time before you can be re-employed.|
|Family responsibilities||No dependents.|
No family obligations (such as supporting aging parents).
|If you have young children, you’ll need to have more money saved. If you have family obligations (such as aging parents, or loved ones who require financial support).|
Is it possible to save too much for emergencies?
In some cases, keeping too much aside for emergencies can hinder your financial progress. That’s because there’s an opportunity cost associated with keeping too much of your net worth in cash or in an investment with limited growth potential. (Learn more about the pros and cons of saving vs. investing.)
Still, you know by now that despite the potential opportunity costs, it’s essential to maintain some emergency savings: think of it as an insurance policy for your financial wellbeing.
How can I build emergency savings
Once you know how much to save, you’ll need to come up with a plan for how you’ll save that money, and by when.
It’s a good idea to set the minimum safety net that you calculated earlier as your starting goal. Once you’ve reached that first goal, you can slowly work towards the top end of that range. You can use our savings calculator to estimate how long it will take you.
Remember: if you have high-interest debt, you should pay that down before saving for emergencies.
Here are two great ways to build your emergency savings:
1. Save a little every time you get paid
If possible, aim to save at least 10% of your income.
At CI Direct Investing, we’re huge advocates of setting up automatic contributions because they work like magic. You can set up recurring transfers from your main bank account into your emergency fund and then sit back and watch your savings grow. Try to line those transfers up with payday so you’re never tempted to spend that money.
2. Stash a lump sum
The fastest way to increase your emergency savings is to contribute any big payouts that come your way. Even if you’re not expecting to win the lottery or inherit a small fortune, you might see an annual cash windfall in the form of a spring tax refund.
Of course, you don’t have to choose between these two savings methods: do both to save even faster.
Where should I keep my emergency savings
Unlike long-term savings (such as an RRSP), you’ll want to keep your emergency funds in cash or in a low-volatility investment that you can access easily without the risk of loss (say, if the stock market plummets) or a significant withdrawal penalty. For that reason, an investment portfolio made up of stocks and bonds isn’t ideal for emergency savings.
So where should you park those funds?
Both a high interest savings accounts (HISA) and many cashable GICs will give you the opportunity to earn some interest, while ensuring the money is there and accessible when you need it.
Let’s take a look at the specific benefits and drawbacks of these options:
Pros & cons of HISAs & GICs
|• You can earn more interest than you would with a standard bank savings account|
• You have the ability to quickly withdraw your money
• Your principal (that’s the value of the money you deposit) may be guaranteed
|• Unlike when you invest, there is only interest earned and not any opportunity to earn additional growth|
• There’s a risk that the interest you earn on your savings won’t keep pace with inflation
• Cashable GICs only: You may lose the interest that you have accrued on early withdrawals
Don’t wait for an emergency to start saving
Maintaining an emergency fund will give you confidence that you can stay afloat financially even as you tackle life’s inevitable challenges.
If you haven’t started an emergency fund, or if you don’t feel that you’ve saved enough, now is the time to start. Follow the steps in this article to calculate your target number, and start building your savings.
And hey, if you’re looking to park your emergency savings in a High Interest Savings Account, we’ve got you covered. Start saving today.