With a lot of uncertainties and unexpected happenings, it is quite glaring that an emergency fund is important. Not everyone understands the need for an emergency fund. If you do not have an emergency fund, keep reading to find out why you may need one.
What Is An Emergency Fund?
Simply think of an emergency fund as a reservoir of cash that is saved up for unforeseen circumstances. Emergency funds are usually set up for things that could happen; they may not happen but could happen.
Think of an emergency fund like setting up an insurance policy for your car. In the case of an accident, your insurance covers a part or all of your new car expenses, however, if you never have an accident, the money doesn’t come back to you, it stays with the insurance company.
An emergency fund, on the other hand, covers expenses on unexpected events. If and when an emergency occurs, you have the cash to fall on to, but if there is no emergency, the money belongs to you (even though you shouldn’t be spending it). Having an emergency fund gives you some kind of comfort, and doesn’t leave you feeling financially vulnerable.
Why do I Need An Emergency Fund?
Having an emergency fund is like planning for unplanned events — sounds cheeky!
But hey! It is what it is. You are planning to afford situations or circumstances that happen out of the blues and require a substantial amount of money.
You need an emergency fund because, although family support can be available sometimes, it’s not always a reliable option. Everyone has individual financial obligations to cater to.
Also, the banks do not always give you money when you need it, and when they do, it doesn’t come free or cheap. The last thing you want to do when you have a financial emergency is spiral into debt.
An emergency fund is important as it takes away financial pressures and stress.
How Much Should Be In My Emergency Fund?
Although a popular rule of thumb suggests having 3-6 months of expenses saved up in an emergency fund, this amount should depend on your specific financial situation.
While emergency funds target a lot of unexpected events, one of the greatest impacts on your financial situation is a job or business loss.
Expenses and bills do not halt when you lose a job and you will need some money to fund your everyday life. This is why you need a buffer that can get you going for at least 3 months until when you get another source of income.
Unfortunately, you can not guarantee how soon you get a job. In a worst-case scenario, which takes up to a year (12 months), you would be left high and dry if all the savings you had was for only 3 months.
In Canada, the government supports the loss of jobs and employment through employment insurance which works like most insurance policies and requires EI contributions/payments as well as other requirements.
Some people may have multiple events that require financial relief at the same time. For example, what are the chances of losing a job and having to incur a huge housing expense you did not foresee in the same period? If this situation occurs, it throws your saved up living expenses off balance and may leave you vulnerable sooner than later.
Ideally, save up an amount that works for your situation depending on your income, expenses, and family unit size.
When Is The Best Time To Start building An Emergency Fund?
You can start building an emergency fund at any time.
There are different opinions on the order of priority for paying off debt and building up your savings. If you do not have any debt or financial obligations to settle, you can start putting aside a portion of your income towards your emergency fund.
The dilemma around whether to pay off outstanding debt before savings is a real one. If you have debt and can simultaneously pay it off while also saving, that would be ideal. However this may exert some pressure on your finances, in this case, you would need to assess your unique situation. If your debt has a very high-interest rate, then you may be better off paying off your debt first before building your emergency fund.
An alternative option may be to build a minimal emergency fund and then focus on paying off expensive debt, after which you can resume saving into your emergency fund account.
How Can I Build An Emergency Fund
The first approach to building an emergency fund is to determine your average monthly expenses. Having an active budget helps you understand where your money goes every month. If you do not already have a budget, you can start one easily. A budget helps you determine your key living expenses such as:
- Rent or Mortgage
- Feeding and groceries
- Medical bills and medication
- Utilities (Water, heating, light and sewage bills)
Alternatively, if you want to build an emergency fund to cover unforeseen events, you could estimate what it would cost to offset an unexpected event such as a car accident or medical expenses and save towards it.
You can get a simple and effective budget template to help you analyze your income and expenses here.
After you have established what your average monthly expenses are or determined an estimate to offset an event occurring, the next step is to start putting aside part of your current income into an emergency fund account.
You can start putting aside any amount on a monthly basis. The goal is to build up a savings amount that is at least 3 to 4 months of your established average monthly expenses.
If needed, you can build up your emergency fund to cover for a longer period of 6 to 12 months or save up to cover multiple events.
It is important to note that you do not want to save up excess money in cash because keeping your money in form of cash does not earn you any returns in the long run.
Where Should I Save My Emergency Fund?
When deciding where to save up your emergency fund, consider these two major factors:
- Liquidity – Ease of access, availability and quick conversion to cash
- Safety – Little to no risk of losing money
It is recommended to put your emergency fund savings in a very liquid account. This is to ensure that you have access to your money when you need it. You can use a regular savings account or a high-interest savings account (HISA) which offers better interest rates on your savings.
If you put your emergency fund savings in stock investments, mutual funds, index funds, or any other type of illiquid investment, you may not be able to convert these investments to cash when you need them.
Also, depending on the financial markets situation, you may lose some money if you sell your investments at certain periods.
What Can I Use My Emergency Fund For?
While monthly living expenses are usually used as a benchmark for building an emergency fund, you can use the money in an emergency fund for:
- Medical emergencies
- Car expenses not covered by insurance
- Major household damages not covered by insurance
- Urgent school expenses
- Other urgent family needs
What Should I Not Use My Emergency Fund For?
There are certain expenses that you should not use your emergency fund for and this usually requires financial discipline. Some of these expenses include but are not limited to:
- New car
- Mortgage down payment
- Minor house maintenance
- Education (You can save up separately for this)
Key Takeaway on Emergency Funds
Emergency funds can relieve you from financial pressures, it can be beneficial to have one. It is important to use your emergency fund for expenses that are classified as emergencies and not for everyday living expenses. An emergency fund should typically be in an account that is liquid, accessible, and relatively safe.
Get a budget template to help you determine your monthly expenses and how much you need to save for your emergency fund.