Having an emergency fund is an important component of your financial life. How much you should set aside and where to keep it varies depending on your situation. If you are a homeowner, have dependents, own a car, have a pet, and own a second property like a cottage, your emergency fund will need to be bigger than someone without these things. Similarly, if you work in an unstable industry, have a single-income household and don’t have any other non-RRSP savings, you should also consider a more robust emergency fund.
One of the only drawbacks of having an emergency fund is that the money usually sits in a savings account earning next to nothing instead of having it in a higher-return investment. This is an opportunity cost: the potential earnings you give up when you choose to keep funds in a savings account. How can you best address this opportunity cost issue? Three ways:
1. Determine how much you should set aside for emergencies.
2. Keep a portion in a savings account.
3. Have a secondary source of savings elsewhere.
This method balances the need for immediately access to the funds with earning a modest return on the money.
There’s no perfect number when it comes to how much you should set aside for emergencies. Everyone’s life situation is unique and, as always when it comes to money, emotions play a role too. Some people prefer to have a bigger safety net than others.
There are two kinds of emergency funds: one for job loss and one for large expenses.
Job loss fund: When determining your job loss fund, here’s one approach you can take:
Create a list of all your expenses to know exactly how much your life costs. Then go line by line and decide which items you would be willing to eliminate or reduce if you lost your job. Create a “just lost my job” budget.
Subtract your spouse’s monthly income (after tax and deductions) from the “just lost my job” budget amount.
If there is a deficit, multiply it by the number of months you estimate it will take you to find another job.
If you have money in your TFSA or non-registered account that you’re willing to use, incorporate this into your plan, lowering the amount of your emergency fund.
Here is an example.
Large expense fund: For your large expense emergency amount, brainstorm the major emergency-style expenses that could come up and estimate the cost. Choose the most expensive one or if you’re particularly nervous, choose two. This is your emergency fund.
If you have a home equity line of credit that you can draw on, then maybe you don’t need anything in this fund. Just be sure that you’re able to repay the loan quickly; otherwise the interest cost will outweigh the opportunity cost of leaving these funds in a savings account.
Also ask yourself how quickly you could replenish this fund if you depleted it with one big expense. If it would take you a while, consider making the fund bigger in case you have two unexpected expenses close together.
What do to with it
Some of the money should be put into a savings account; the remainder can be invested in something that earns more interest.
Savings account: For the large, unusual expenses fund, set the money aside in a savings account. It’s possible that you’ll need access it quickly so it should be easy to get to. For the layoff emergency fund, you won’t need the money all at once – it will be required in a steady stream over time. Consider leaving two months’ worth of expenses in a savings account and investing the rest in something that can earn you more.
Options for other emergency savings: For the money you might not need immediately - like the rest of the “job-loss” fund and extra “large expense” money - there are a few options.
High interest savings ETFs: These ETFs invest in high interest savings accounts of Canadian banks. The interest rate is attractive right now but will fluctuate. You can easily take the money out of the ETF, but you’ll need to place a trade and give it a day or so to be accessible to withdraw depending on where your account is.
Short-term GICs: You can buy short-term guaranteed investment certificates that mature in as few as 30 days. This would be appropriate for the job-loss fund, since you can use the funds in your savings account for the first month or two while you wait for the GIC to mature.
Cashable GICs: GICs are usually non-cashable, meaning you can’t access the money until they mature. Cashable GICs are exactly what they sound like: you can take the money before maturity. This can be a good option, just be aware that the rate on these GICs will be lower than a regular GIC.
Setting aside an emergency fund is one of the foundations of a financial plan. Although you want to keep it simple, it’s worth taking the time to determine the optimal amount you’d need immediately and how much can be slightly less accessible.