If there is anything we have learned the past few years, it is to expect the unexpected. From a worldwide pandemic to war in Europe to the highest inflation in decades; we have been confronted with large, unexpected events. This has driven home the importance of having a safety net to protect from these shocks.
An emergency fund is intended to protect you and your family from these shocks and help you weather financial setbacks without getting pushed off course.
It will keep you from entering debt to cover unexpected expenses or tapping into your retirement savings to cover a work absence due to a month-long accident/illness. It is also there to provide peace of mind and free you up to be more aggressive with your other investments.
An emergency fund is typically suggested to equal three-to-six months of basic living expenses. Depending on your situation it may make sense to have even nine or twelve months worth.
Figuring out your monthly spending means tracking your expenses for a few (at least three) months. If you cannot bring yourself to complete a full tracking of your spending then just average three months worth of your income (paycheque, pension, RRIF withdrawals etc.) to get a rough estimate of monthly needs.
Now you must decide how many months of expenses to cover. This depends on your personal situation and risk tolerance. Here are questions to consider:
- Is your job and pay stable? If no, then the higher end of the range would be better.
- Do you often worry about money? If money is a significant stressor for you, then have a larger emergency fund.
- Are you a one-income household? If yes, then yet again, have a larger fund.
- If retired, is most of your income from guaranteed sources (pension, CPP, OAS)? Yes, then a smaller emergency fund is reasonable.
These are just a few of the relevant considerations when determining the size of your emergency fund. Keep in mind your emergency fund shouldn’t be too large either. It is only to provide safety for financial shocks, it is not meant for long-term investing goals.
Where to Keep your Emergency Fund
The most important characteristics for the emergency fund are liquidity (easy accessibility) and safety from loss. If you can earn a small return, even better. For these reasons keeping it in a high interest savings account is ideal. In a chequing account you won’t earn any (or much) interest. Also, a locked-in product is not a good fit. An emergency fund is useless if you can’t access it when an emergency arises.
Most banks will offer a high-interest savings account and online banks tend to have the best rates. There are also mutual fund and ETF high-interest savings accounts available.
Don’t keep your emergency fund inside of your RRSP/RRIF as you will need to pay taxes when you withdraw the money. If you have TFSA room, it can be kept there, but you will eventually use your TFSA to hold long-term investments.
To begin building your emergency fund, start by setting up automatic weekly, biweekly or monthly withdrawals from your chequing account that go straight into your high-interest savings account.
Once your emergency fund is fully funded move on to paying down debt or investing for other goals. Do not skip setting up an emergency fund, it is an essential step towards healthy finances and reduced financial stress.