“You can’t control the uncontrollable, but you can expect the unexpected.”
This post is all about emergency funds. We’ll start by exploring the importance of emergency funds and why people should have them. Then we’ll review how much money should be in an emergency fund and talk about the various places that money can be saved. Finally, we’ll discuss how to begin saving towards your emergency fund.
What is an emergency?
There is much confusion over the nature of an emergency. This question is best answered by talking about what an emergency is not. An emergency is not a monthly occurrence like paying your rent or your phone bill. It’s not Garth Brooks tickets or a weekend with the girls. It’s not even those irregular expenditures that should be anticipated like annual taxes, dental checkups, or new shingles on your house.
An emergency is not a want. It is a need that came up unexpectedly even though you did your best to create a reasonable budget. Valid emergencies are as follows:
- Sudden unemployment
- Major appliances crap out (furnace, refrigerator, stove)
- A health crises in your family
Emergencies will happen
Being struck by lightning is an unforeseen circumstance, losing your job or having a family member take ill is not. Although you can’t plan for a specific emergency in any given year, you should come to expect that they will happen several times over the span of your life. Yes, you can and should plan to have unknowable shit happen to you. Don’t be unprepared.
What is an emergency fund?
It’s a common misconception that emergency funds have to be 3-6 months of cash sitting in a savings account. This makes for a very simple rule of thumb that is completely inappropriate in many circumstances.
An emergency fund is a well thought out strategy that allows you to reasonably access several months worth of living expenses. This conversation usually starts when people discuss debt management, since the emergency fund is the buffer between life throwing curve balls at you and debt. It is an integral part of the foundation that makes your life financially shock-proof.
How much money should I have in my emergency fund?
The amount of money you should have in an emergency fund depends on two main factors:
- How much you spend each month
- How stable your employment circumstances are
1. How much you spend each month
There is no requirement for you to completely replace your income each month unless you spend 100% of everything you take home. If you do this, please stop now. This puts you in an extremely vulnerable financial position and you need to plan your way out of it as soon as possible.
Close your eyes and picture getting laid off tomorrow. What amount of money would you need to survive in the short term? What activities and entertainment could you reasonably cut back on? Ensure you don’t count savings in this number, it’s okay to stop saving for a vacation or retirement during a valid emergency.
2. How stable your employment circumstances are
As a minimum value, use 3 months of spending as your starting point. Then take stock of how likely you are to experience unplanned unemployment. Although emergency funds are not solely used for unemployment, this scenario will give you the other bookend.
For example, if you have a highly specialized field in a narrow industry, you may want to extend your fund to cover 9-12 months of expenses. Alternatively, if you have multiple income sources, you may be comfortable with 3-6 months of emergency coverage.
To determine how much money you need accessible, multiply your monthly expenses by how many months coverage you reasonably need.
Does my emergency fund need to be in cash?
No, your emergency fund does not need to be sitting in cash! Recall that an emergency fund is a strategy that allows you to access several months worth of living expenses. There are a variety of forms that an emergency fund can take, and they can offer you various layers of protection. Here are a few examples, listed in order of lowest to highest risk tolerance:
- Cash in a savings account
- Conservative investments in a TFSA or Unregistered account
- Aggressive investments in a TFSA or Unregistered account
- Family with means and inclination to help you through a tough time
- RRSP savings
- An untouched Line of Credit
- Extra credit on Credit Cards
(Note that options 5 thru 7 are not ideal and should only be used as a temporary bridge between now and options 1 thru 3)
Your personal circumstances have a massive impact on your emergency fund strategy. Consider a couple that has $50k of consumer debt. Their only reasonably safe strategy is a cash account, because they need a buffer against sliding into more debt.
What about a household that has $100k of additional investments in TFSAs? They have no need for more than 1 months worth of cash in their bank account as 6 months worth of cash savings would only decline in real purchasing power over time.
How about a 27 year old bachelor that has a middle-class supportive family? Maybe he needs no savings as his backup plan is to move in with his parents if things go sideways on him.
In addition to considering your personal situation, your emergency fund strategy should be evaluated periodically as you accumulate wealth. Once consumer debt has been eliminated, it is likely that you can keep a smallish amount in cash and focus on investment asset growth.
How do I save for an emergency fund?
Now that you know how much you need in an emergency fund and what form it should take, you need to slowly start building it up. It is important that you don’t freak out, as it takes time and patience to get to your calculated number. The creation of an emergency fund starts with you including it as a line item in your budget. It does not necessarily take precedence over debt repayment or investing, but needs to be balanced between the other priorities you have identified. Many people find that even small amounts of emergency cash can lessen their anxiety while they work towards several goals at the same time.
Emergencies can and should be expected to happen in our lives. Unfortunately, we don’t know what form or shape they will take and when they will arise. It is important to have a well thought out emergency fund strategy and begin saving towards a financially shock proof life by including a line for emergency savings in our budgets.