An emergency isn’t something anyone wants to contemplate. But the reality is that most people encounter some sort of emergency during their lifetime, and it may be one that affects them financially. And whether a crisis is job-related, health-related or something else, an emergency fund can provide a financial safety net and help you get through the crisis.
What is an emergency fund?
An emergency fund allows you to sustain your household in a time of crisis. If something interrupts your usual income level, or you incur much higher costs, an emergency fund allows you to keep up with your living expenses.
Why do I need an emergency fund?
An emergency fund is useful if you encounter a crisis that interrupts your normal financial well-being. It could be a job loss or a health emergency, or a costly and unexpected repair to your home. If you haven’t set aside an emergency fund, you could find yourself having to dip into your other investments or take out a loan.
Having to cash out your investments in an emergency could force you to sell stocks, mutual funds or exchange-traded funds at the wrong time. If these holdings were invested for the long term, you may be liquidating them just when the market is in a downward swing, which could lead to a loss when you sell. If you hold a bond or guaranteed investment certificate, early cashing penalties could be levied, and you could lose out on any interest earned.
And if you need to turn to your registered retirement savings plan (RRSP) for emergency funds, there will be withholding tax of up to 30% levied on your withdrawal and you’d have to claim it as income for that year’s tax return. In a case like this, a withdrawal from a tax-free savings account (TFSA) would be a better choice because you don’t pay withholding tax, and you don’t lose your TFSA contribution room, which lets you start building back your TFSA savings again the following year, after the crisis is over.
Turning to a loan or your credit cards during a financial emergency also isn’t ideal. You’ll be taking on debt and paying higher interest rates – which means the financial emergency will end up costing you more. Some rely on a line of credit as an emergency fund. These generally have significantly lower interest rates than a credit card, but you would still pay interest and take on more debt, which could be a source of greater stress.
How to build an emergency fund
The purpose of an emergency fund is to have money accessible for a specific number of months. How many depends on your personal situation. The best way to start is to plan for the most likely emergency, an employment gap of some sort.
- If you consider your industry and location, think about how long it could take you to get re-situated. That estimated length of time provides a good target for the number of month’s funding you need to save.
- Review your spending for the last year, and remove anything that was a luxury, or could be deferred in an emergency. Add up what your necessary spending was and divide the total amount by 12 for your monthly average. Now multiply that amount by the number of months you need to save for. This provides a good guideline for your target emergency fund amount.
- Determine a regular deposit to your emergency fund, ideally an automated deposit that is aligned with your pay cycle. You can assign a dollar amount or a percentage of your pay that you can commit to, even if it’s just a small amount.
- Now, divide your emergency fund target amount by your deposit commitment – which will show you how long it will take to get to your target emergency fund amount. Time for a gut check – if reaching your emergency fund target will take years, you might be more comfortable bumping up your savings commitment. You never know when that emergency will hit, so it may be worth a little sacrifice to your usual budget to get to the goal faster.
The Ontario Securities Commission has a handy Emergency Fund Calculator that helps you to calculate your expenses in detail to estimate how much money you should set aside for financial emergencies.
The information contained in this article was obtained from sources believed to be reliable; however, we cannot guarantee that it is accurate or complete. This material is for informational and educational purposes and it is not intended to provide specific advice including, without limitation, investment, financial, tax or similar matters.