An emergency fund is the first line of defense for your financial life.
Emergency funds provide a cushion for anything unexpected – this could be an emergency car repair (or replacement), a lost job, home repairs, or any other major expenses that you don’t plan for. By having one in place, you can handle these adverse conditions and mitigate the damage it will cause. Though having to dip into an emergency fund isn’t ideal, it’s better than the alternative of liquidating assets or going into debt.
If you haven’t already, you need an emergency fund as part of your financial life, and in this article we are going to explore:
- Why you need an emergency fund
- How big should your emergency fund be?
- How to set up an emergency fund
Why You Need an Emergency Fund
Emergency funds reduce the damage that an unexpected expense can have on your financial life.
When an unexpected expense comes, you often have no choice to take care of it by any means necessary. When you don’t have a fund set aside to deal with this, you will need to resort to taking on (often expensive) debt, or a fire-sale of an asset.
Let’s imagine that you unexpectedly lose your job. The money you had coming in on a monthly basis is no longer coming, but you’ve still got bills to pay. If you didn’t have funds in place for that situation, maybe you start putting all your expenses on a credit card, or maybe you withdraw money from an investment account (potentially incurring expensive fees). Once you’re through the crisis (i.e. you get another job), paying off those high-interest credit card bills or rebuilding your investment account is not something that will happen quickly. It may take years to fully recover and get back to where you were, all because you had no line of defense between the world and your finances.
When you don’t have an emergency fund in place, not only do you have to deal with the cost of the event, but you also have to deal with the long-term consequences of taking damaging action. Having an emergency fund in place prevents all that, and is specifically meant to deal with that situation.
So if you haven’t already got one set up, you need an emergency fund in place.
How Big Should Your Emergency Fund Be?
An emergency fund should have enough money to cover 3-6 months worth of living expenses.
Now it falls on you to determine a) what is considered a living expense, and b) how many months of expenses you want to hold. If you have a greater tolerance for risk, you could hold a smaller emergency fund, or if you’re risk averse, you could hold a bigger emergency fund.
Living expenses at the very least should incorporate things like housing, groceries, minimum debt payments, insurance, etc., all things that are non-negotiable (see this article for tips on classification). You could also expand this a little to have some funding for activities or experiences, but just know that that will increase the amount of money you need to hold in your emergency fund. The other thing to consider is how much risk you have in your life. How secure is your job? Are you at risk of lay-offs, or are you an integral part of the organization? What large expenses could come your way? Do you own a home or car that could have large unexpected expenses? All of these factors will affect how many months worth of expenses you should hold.
How big your emergency fund is depends on your individual risk factors, and these things can change throughout your life. It’s important that you assess (and re-assess) how big your emergency fund should be, and calculate the amount you’ll need. Take a moment now and figure out how much you want to save.
Now that you know how big your fund needs to be, let’s talk about how to get one set up.
How to Set Up an Emergency Fund
Setting up this financial shield can be done in four steps:
1. Calculate How Much You Need
As mentioned above, you should keep 3-6 months worth of living expenses. Track your expenses to understand how much you spend on living, determine your risk factors, and decide on your number.
2. Open/Designate An Account
I’d recommend using a High-Yield Savings Account as this allows you for some growth, but still allows for easy access in the case of emergency. I would not recommend using a registered account like a TFSA as you’ll lose out on the advantages of the account.
3. Allocate Funds In Your Budget
In your budget, allocate some or all of your savings towards this account. If you can, automate this savings so it gets moved automatically everytime you get paid. That way you don’t have to think about it.
4. Stick to the Plan
Emergency funds may not be flashy, but they’re instrumental in your financial health. Stick with it until you hit your number, at which point you can start doing more exciting things like investing. And remember, the emergency fund is for real emergencies, not things like buying clothes or a vacation.
Conclusion
Emergency funds are the first line of defense for your finances. You hope to never need it, but if you ever do, you’ll be thankful you have it. By having one, you allow your wealth to grow behind that shield, setting you up for long term financial prosperity.
So if you haven’t already, do your future self a favor and take the first step today.