Emergency funds serve as a shield for your finances, protecting them in case of an emergency. But there are mistakes that can be made in the process of building or holding an emergency fund. Read on to learn 10 common emergency fund mistakes to avoid.
Not Having an Emergency Fund
The first, and greatest mistake is not having an emergency fund at all.
Emergency funds exist to prevent you from having to take damaging action to deal with an urgent expense. This damaging action could be taking on expensive debt, selling investments, or fire-sale of an asset. All of these actions could have long-term effects on your financial health.
If you haven’t already, take the steps towards setting up an emergency fund.
Not Saving Enough
Not saving enough in your emergency fund means that you will not have enough to cover emergency expenses.
In general, it’s recommended that you hold 3-6 months of expenses in your emergency fund. It’s important you track your spending to understand your monthly expenses, then determine the dollar amount that makes sense for you situation. Holding too little could result in having to take damaging action, such as using expensive debt or selling assets.
Make sure you’re holding enough in your emergency fund.
Not Considering Your Risk Factors
When considering how much to hold in your emergency fund, you need to consider your risk factors.
Risk factors can include the following:
- Do you work in a volatile job/sector where job loss is common?
- Do you have dependants who rely on your income?
- Do you own assets (e.g., car/home) that may need emergency repairs?
- Is there a safety net (e.g., family) in case you run out of money?
These risk factors will inform the number of months of expenses you hold in your emergency fund.
Ignoring Bad Debt to Build Emergency Funds
Building an emergency fund is great, but if you’re ignoring bad debt to do it, you could be causing damage.
Emergency funds exist to prevent having to take on bad debt (e.g., credit cards) in the case of emergency. But if you’re already in a situation where you have bad debt, you are better off taking care of that before building your emergency fund.
If possible, you could pay off debt while building an emergency fund, but never ignore bad debt to build your emergency fund.
Saving Too Much
Emergency funds are a great shield for your financial life, but holding too much in an emergency fund creates opportunity cost.
Emergency funds will typically diminish in value over time due to inflation. This can be combatted by holding them in a high-yield savings account, but ultimately emergency funds do not exist to grow your wealth. By holding too much in emergency funds, you’re costing yourself the potential growth on investments.
Make sure you’re not holding too much in your emergency fund, and you’re putting your non-emergency money to work.
Investing Your Emergency Fund
When you face an urgent expense, you want your emergency fund to be there in the amount you expect.
If you invest your emergency fund, you are subject to market volatility. If a market downturn occurs at the same time as an emergency such as a job loss (which they often do), you may have less in your emergency fund than you expect.
The point of emergency funds is not to grow in value, but rather protect your finances in case of emergency. Save the investing for other funds, and hold your emergency fund in cash.
Holding Emergency Funds in Registered Accounts
Registered accounts (such as TFSAs/Roth IRAs, or RRSPs/401k) typically have tax advantages, but often also come with withdrawal limitations.
Emergency funds should be liquid, so you don’t want any withdrawal limitations or penalties hindering you from withdrawing the money when you need it. As well, since emergency funds should be held in cash, the growth will minimal, meaning any tax savings will be negligible.
Reserve your registered accounts for investments where you can maximize tax savings, and hold your emergency fund in a non-registered high-yield savings account.
Using Emergency Funds for Non-Emergencies
Emergency funds should be used for emergencies and only emergencies.
It’s important that emergency funds are held separately from other funds, and they are never used for a non-emergency. If you mix your emergency funds in with other money, the lines get blurry. As well, if you start using your emergency fund for non-emergencies, it’s hard to stop. Then you may find yourself in a situation where you have an actual emergency, and your emergency fund is less than you expect.
Hold emergency funds separate from other cash, and never use them except for a real emergency.
Holding Emergency Funds in Physical Cash
Physical cash will lose value with inflation, meaning your purchasing power will slowly diminish.
Inflation targets typically are 2-3%. This means that each year, your cash will have 2-3% less purchasing power. Holding an emergency fund in physical cash means inflation will reduce the purchasing power. However if you hold it in a high-yield savings account, the interest rate will decrease the effects of inflation.
Hold your emergency funds in a high-yield savings account, and not in cash.
Failing to Replenish After an Emergency
There will come a day that you need to use your emergency fund, and it’s important that you rebuild it after the emergency is handled.
As much as you hope to never need your emergency fund, it’s inevitable that things will arise. When that happens your emergency fund, if well funded, should handle the expense. But once that occurs, you’re unprotected again. It’s important you budget to rebuild your emergency fund for the next emergency that comes up.
Failing to replenish your emergency fund after an emergency leaves you unprotected.
Emergency funds act as a shield for your financial life. Having an emergency fund in place prevents you from having to take damaging action in the case of emergency. By avoiding the mistakes outlined here, you can maximize the effectiveness of your emergency fund, and protect your financial health.