What is an emergency fund?
An emergency fund is a sum of money saved to cover major unexpected expenses such as:
- Urgent major repairs (not renovations) to your home or car
- Unexpected medical expenses not covered by universal health care or insurance
- Lack of income due to job loss
This fund is different from a regular savings account for everyday expenses or future planned purchases. An emergency fund is a financial safety net designed to cover expenses or bridge the temporary loss of income between jobs. It’s also there to prevent the use of your retirement savings, or high-interest debt, such as credit cards and payday loans.
According to the Government of Canada, 64% of Canadians have an emergency fund to cover three months’ worth of expenses, so most of us are on the right track.
Why do I need an emergency fund?
Just like the name implies, an emergency fund is meant for emergencies. Unexpected events happen in life: The car breaks down, the fridge stops working or you get laid off during a recession. Without an emergency fund to help cover your expenses, you could end up paying bills with a credit card, relying on payday loans or heavily using your secured or unsecured line of credit.
All these options charge interest, but the credit-card and payday-loan rates are very high. Canadians pay an average of 19.99% on credit cards. They pay even more on a payday loan, which has an annual interest rate of 442%, according to the Government of Canada.
While these services offer access to money, you’ll have to pay them back right away to avoid interest charges, which quickly begin to add up. Making required payments may leave you short of money until your next pay, and you may end up needing to use a credit card or take out another payday loan to fill the gaps. This creates a cycle of debt which can be very hard to break.
A line of credit might look like a better option because the interest rate is significantly lower than a credit card or a payday loan, but there are some things to know before you borrow money this way.
A secured line of credit is usually tied to an asset—such as your home, in the case of a Home Equity Line of Credit. A HELOC is intended to help finance home improvements and can be used for financial emergencies once it’s paid off.
Just trying to make sense of the numbers… The article states “According to the Government of Canada, 64% of Canadians have an emergency fund to cover three months’ worth of expenses, so most of us are on the right track,” yet we often hear that “Nearly Half of Canadians (48%) Are $200 or Less Away from Financial Insolvency” (Ipsos.com). Assuming there is also a third group of people sandwiched in between these two groups, those who have some emergency funds but not three months worth, I’m trying to figure out why the total is greater than 100%. Perhaps some are counting their available credit as their emergency fund?
What about return (cost of opportunity) you are missing, if you are keeping all life money in cash equivalents (emergency fund)?
For my household, I keep a combination of extra money in chequing, a HISA and TFSA (bond ETF). Outside of a job loss, I should never have to go to my TFSA.
I struggled with the concept of opportunity cost, but I read that you should never have money in stocks when your horizon is less than 5 years. The statistics back up this rule so I’m happy if I can keep close to inflation.
This depends on a lot of factors though. For example, our must-have expenses are about 50% of our income, 10% is spending on entertainment and we save 30% for retirement and a portion goes to “goals” like vacations, new car, home improvements etc. In the case of a job loss, employment insurance will cover about 50% of our income for 6 months and my mortgage is insured so it drops to 50% when I or my wife loses employment. This way, if either me or my wife loses our jobs, insurance covers all of our expenses for 6 months. The main thing is this – if you can live below your salary, go for it. I work with people who earn less than I do, but they drive cars that cost 5 times as much as mine. McDonalds everyday for breakfast, smoka a pack a day etc. We still enjoy our lives even though we live below our means. The main thing you need to learn – budget your spending, that way you still get to enjoy life and go out over weekends, just keep it in moderation. Most people want to keep up with the Jones’s. My 2013 Ford Focus will get me just as far as your 2021 Mercedes or BMW, because I look after it and keep it maintained. It’s not that difficult, people just don’t want to hear the cold hard truth because it hurts their feelings.