What is an emergency fund and how to build one

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. 

An unsecured line of credit isn’t tied to an asset for collateral, so the interest rate is higher than a secured line of credit. 

The issue is, lines of credit aren’t actually “savings.” Sure, you can take out money, but you have to pay it back with interest. It may take a long time to settle the debt, depending on how much you borrow. And, it can hurt your credit score if you default on any payments. That can prevent you from making future big purchases and stop you from getting additional loans at a good interest rate. And there’s the stress of having to pay back what you owe.

While using a line of credit for emergencies is an option if you don’t have an emergency fund, it’s better to use your savings before tapping a line of credit. 

How much should I keep in an emergency fund?

The traditional advice was to save three to six months of expenses in an emergency fund. The old rule of thumb doesn’t apply anymore because most Canadians struggle with debt, carrying an average of $72,500, according to Equifax Canada. That three to six months’ worth of expenses would go entirely towards debt repayment. 

So, what can you do? 

While aiming to save that ideal nest egg of three to six months worth of fixed expenses is always the plan, just try to save as much as you can within your budget, factoring in debt repayment. 

If you’ve had your current job for several years, you may be fine with three months’ worth of expenses. If you lose your job, you may receive a severance payment from your employer, and likely qualify for Employment Insurance (EI). 

However, if you’re self-employed, a contractor, work on commission or are a gig worker, six months is a safer estimate, as you may not qualify for EI to help you cover necessary expenses while you search for more paid work. 

What qualifies as an emergency?

An emergency is any unexpected, necessary expense. It is not something that recurs or is part of everyday life. Emergencies include: 

• Medical, dental or veterinary emergencies
• Car emergencies, like accidents, repairs or insurance deductibles
• Home repairs, like furnace replacement, basement floods or the breakdown of a major appliance 
• Unexpected job loss
• Acts of nature resulting in property damage or loss

Advisors suggest asking yourself these three questions: 

• Is this event unexpected? 
• Is it necessary? 
• Is it urgent? 

The more you answer “yes” to any of these questions, the more you need to access your emergency funds.

What doesn’t qualify as an emergency?

Several situations might feel like an emergency but may not be. These include:

• Property tax payments
• Vacation (it just feels like a necessity) 
• A baby 
• A new pet
• A new car 
• Weddings
• Annual car expenses, like license renewals
• Buying investments
• A down payment on a new home
• A good sale at your favourite store

Ask yourself if the situation is unexpected, necessary and urgent. With these situations, you should not use your emergency fund. If you need to set further limits to avoid using your emergency fund, make sure it isn’t connected to your debit card. That way you won’t be tempted to do spontaneous spending. 

How to build an emergency fund

Saving for an emergency fund is different from investing or planning for retirement. When you invest, your money is tied up in stocks, mutual funds or exchange-traded funds (ETF) and isn’t liquid. Investing is a way to increase your wealth and is part of a long-term plan. 

Saving for an emergency fund isn’t about long-term goals, increasing your wealth or planning for retirement. It’s about having immediate access to cash. 

So, how do you start an emergency fund?

• Create and analyze your monthly budget to see what you can afford to put aside in savings
• Set aside a certain amount each month or each paycheque 
• Set up either a Tax-Free Savings Account (TFSA) or High-Interest Savings Account (HISA)
• Disconnect it from your debit card so you won’t spend it
• Pay yourself first
• Automate those payments

1. Set a monthly budget and find out what you can set aside each month

• Choose your budget tracker of choice. It could be Excel, an online tool or an app of choice
• Collect receipts, bills and pay stubs for the past six months. Some expenses will be the same amount each month (mortgage, rent, credit cards), while others might change depending on usage (hydro, entertainment, food, transport) 
• Enter those numbers into the budget (if numbers differ monthly, use the average)
• Be as accurate as you can–look at the information you’ve added and adjust, add or subtract as needed
• Review your budget to see if there are any categories where you can spend less (some budget apps offer suggestions where you can cut back) 

Some experts suggest saving 10% of your salary, but if that’s difficult, start by saving what you can, even if that’s $10 to $20 a month. TFSA savings accounts and high-interest savings accounts offer a higher interest rate than traditional savings accounts, so your money can compound at a higher rate over the same period of time. 

If you have debt, you’ll want to pay that off as quickly as possible because the debt’s interest rate is higher than the earn rate on your emergency fund. That way, once you’ve paid off the higher-interest debt, you can redirect that money towards your emergency fund, which should feel pretty easy to do, because you’ve already developed the habit of saving money.

2. Choose the right savings account for an emergency fund

Where should you put your emergency fund? There are two ideal options: inside a TFSA, or a regular high-interest savings account.

Tax-Free Savings Account

A TFSA is a registered investment or savings account that allows you to invest in a number of different instruments, including ETFs, stocks, bonds and cash, for tax-free gains. The amount of money you can deposit is limited to $6,000 per year, to a lifetime maximum total contribution amount of $69,500 as of 2020. Any amount you don’t use in a given year remains available to you going forward, so it isn’t a “use it this year or lose it” situation.

TFSAs are very flexible and are the best option for an emergency fund because you can use them for any short- and long-term savings goals, and you can make tax-free withdrawals. (RRSPs, on the other hand, require you to claim any withdrawals as income.) TFSA savings accounts can also offer a higher interest rate than the average savings account, currently around 2.0%.

High-interest savings account

High-interest savings accounts are just what you’d expect. They pay higher interest than standard savings accounts, which makes them a good option to deposit your emergency fund. Most of them offer an average of 2.0%, up to a certain balance amount. And most banks and credit unions offer their own version of a HISA.

Take the time to compare different options when looking at HISAs, because some will charge transaction fees. But there are several options that are no-fee and don’t require a minimum balance.

3. Pay yourself first

Personal finance advisors are fans of the “pay yourself first” savings technique because it’s a secure way of building up savings. 

It’s pretty simple: You put your savings goals first, so as soon as you get paid, you immediately put a predetermined amount of money into your savings account of choice. The best way to follow this method is to automate the transaction. That way you don’t see the money coming out of the account where your paycheque is deposited, but you will see your emergency fund grow. 

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