Emergency funds are a great way to protect your financial health in the case of an urgent need for money. But it’s important to be thoughtful of where to hold your emergency money, and a checking account is not a good option. Here’s why you shouldn’t keep emergency funds in checking accounts.
Emergency funds should not be kept in checking or transaction accounts for three reasons: Checking accounts earn little to no interest, it’s harder to track balances in a checking account, and you may dip into your emergency fund unintentionally. Emergency funds should be held separately.
When deciding on an emergency fund account, there is a clear winner. Read-on to find out more.
Why a Checking Account is a Bad Fit for an Emergency Fund
Checking accounts are great for day-to-day transactions, but are not a good fit for emergency funds.
There are three things that make checking accounts a bad choice for emergency funds: Little to no interest, difficulty tracking balance, and ease of use of emergency money.
Checking Accounts Offer Little to No Interest
Most checking accounts offer little to no interest on the balance of the account.
The point of a checking account is not to produce growth, but rather allow for easy transactions. With your emergency fund, you aren’t planning to have regular transactions, and if all goes well, the money will just be sitting idle. This money could remain untouched for months or years, and in that time you’d like to get some return on it.
Checking accounts will not offer any (tangible) return on your emergency fund.
It’s Difficult to Track Your Emergency Fund Balance in a Checking Account
When emergency funds are held in a checking account, they’re often held alongside other money. Your checking account typically serves as the entry and exit point for your bank. So when money comes in or goes out, your checking account is usually the first or last stop.
As such, if you hold your emergency money in your checking account, it becomes very difficult to keep track of the balance. This means you could accidentally be holding more or less than you want to. Emergency funds should be held in a separate dedicated account.
Holding an Emergency Fund in a Checking Account Makes it Much Easier to Spend
As mentioned above, checking accounts are where most of your transactions will occur. When you hold your emergency fund in your checking account, it becomes much easier to access this money, and accidentally (or non-accidentally) access this money for a non-emergency.
Imagine you have a credit card bill that is larger than usual that gets paid off from your checking account. If your emergency funds are in your checking account, you may dip into that money to pay back this non-emergency spending. Emergency funds should be completely separate from your day-to-day spending, and using the funds should be an explicit choice.
Checking accounts are not a good choice for emergency funds. Emergency funds should be held separately from your other money, in an account that is liquid and safe. Read on below to see our recommendation for the best emergency fund account.
What is the Purpose of an Emergency Fund?
Emergency funds are a shield for your finances. An emergency fund exists to protect your financial health in case of an emergency.
An emergency fund will allow you to deal with a large expense without damaging your financial health. This expense could be an unexpected job loss, an emergency repair, or a unexpected medical bill. Having an emergency fund in place helps you avoid taking action that may have long-term financial consequences.
In the absence of an emergency fund, the actions you may need to take to deal with this emergency could be much more damaging.
You may take on expensive debt (think credit card debt) that could take years to pay off due to the high-interest, and affect your credit score.
It may also mean that you have to withdraw from your investing accounts. This could result in penalties (for registered accounts) and severly hamper your long-term growth.
It could also result in the fire-sale of an asset, such as your car or home. Due to the urgency, you make take a lower amount than what it’s worth. It may also force you to part with something that’s important to you (e.g. jewelry with sentimental value).
Having an emergency fund in place avoids all this. It is used to deal with these emergency situations such that the damage is minimized. It’s important though that this fund is protected, and only used for real emergencies.
How Much Money Should be in Your Emergency Fund?
Emergency funds should hold 3-6 months of expenses.
The actual dollar amount will depend on your lifestyle and situation. It will depend on what you consider a living expense vs. something that can be eliminated in case of emergency. It also will depend on how much risk exists in your life in the form of assets that may need repair, or probability of a job loss.
It’s important you assess your individual circumstances to find how much you need. From there, you can budget to build your emergency fund.
What is the Best Account for Emergency Funds?
The best emergency fund account is both liquid and safe. This means the money is easily accessible, and is available in the amount that you expect. Our recommended account for your emergency fund is a high-yield savings account.
Liquidity
Liquidity is important for emergency funds. When an emergency occurs, you want to make sure you can easily and quickly access your funds. You don’t want to be penalized for withdrawing, or worse not be able to withdraw at all. As such, accounts like GICs or holding in physical assets (real estate, precious metals, etc.) is not recommended. High-yield savings accounts allow you to hold your emergency funds in cash, and quickly access it when needed.
Safety
Safety is the other consideration for emergency funds. You never want the value of your emergency fund to drop, and leave you stranded in case of emergency. As such, you should hold your emergency fund in an account that has no possibility of dropping. For this reason, investing your emergency is not recommended as a market drop could slash the value of your emergency fund. And often, this market drop will coincide with an economic slowdown and lay-offs. High-yield savings accounts have no possibility of dropping, and will provide some return on your money.
The last big consideration is if you should hold your emergency fund in a registered account. Generally, holding an emergency fund in a registered account is not recommended. Accounts like RRSPs (or 401ks) have withdrawal implications, meaning the money isn’t liquid. Though these withdrawals limits don’t exist for all registered accounts (e.g.TFSAs (or Roth IRAs)), registered accounts have significant tax advantages, which are best used for investments. Emergency funds are best held in a non-registered accounts, so your tax savings can be maximized through investing.
Emergency funds are best held in a non-registered high-yield savings account. This allows for liquidity and safety, while also providing some return on your money. It also allows you to reserve your registered accounts for investments, where you can maximize tax savings.