Emergency Funds

Until recently, I never really saw the need for an emergency fund. Financial experts (and financial book writers) always stressed the need for three to twenty-four months of expenses to have saved in the case of an emergency (like losing your job). Others call it the "sleep well at night factor", that you feel better about yourself and your finances if you have several thousand dollars at hand.

I have started an emergency fund, which I have yet to touch. It will only end up with a few thousand dollars in it at the absolute most, because I have a tough time conceiving an emergency that will cost more than that. Why did I decide to do this? For a few reasons, but mainly because I always feel it is better to be ahead than behind, and my old emergency fund plan would put me behind financially.

What was the old plan? Probably the same as most peoples: credit cards and lines of credit. What I did several years ago was dip into a line of credit or a credit card whenever I needed money, whether it was an "emergency" or not. If I needed money for something, I would either borrow it (from family or my "emergency" fund) and then be behind financially. By just having a few thousand set aside, if I need this money for anything I will just be able to access it.

My old self would say "how can you just leave the money sitting there? Shouldn't you either be using it to pay off a bill or to invest in an RRSP?". My lines of thought have changed that if you don't have at least $1000, the potential for large hits on a credit card or line of credit in a year are inevitable. My money goes into my Tax Free Savings Account, so it is still invested in low-cost mutual funds, so I'm not losing any savings potential.

I give regular contributions to this fund. When I get significantly over $1000 (or whatever number I choose...I am approaching $1000 now) I can then choose to do something with the excess money (an extra pay on my mortgage, a last minute investment in my RRSPs, a down payment on a second property (hint, hint)). By not having an emergency fund, I open myself up to the possibility of constant borrowing, and we all know that you can only get ahead by savings (and investments) rather than borrowing.

Emergency Fund

The question that I am posing, and hoping to answer, is how much money is enough for your emergency fund. An emergency fund is intended to be used, of course, in an emergency. My definition of an emergency is a) when you lose your job, b) when something unexpected happens, c) a cushion in case of unintended expenses.

A good suggestion that I got from Million Dollar Journey is to begin by having $1000 in an emergency fund, then pay off your loans, etc. By having $1000 set aside, you should never need to go to your credit card, or lines of credit or anything like that in the case of an emergency. If your motor goes on your car, or you need to buy a new roof or whatever, this money is intended for stuff like this, so you don't need to borrow in order to cover it.

In these tough economic times, there is a threat for everyone of losing his or her job. Of course, you are saying, "This could never happen to me", but for everyone that is a realistic concern. I would recommend having at least three months expenses saved up in an emergency fund in case of job termination. What are three months expenses? Basically these are your fixed expenses (less investments): mortgage (or rent), food, monthly bills, loans, etc. If you lose your job, likely investments and variable expenses will be pulled back. In three months, you should be able to recover financially and find another job (one would hope).

In the same way, if you have a rental property, you should also have an emergency fund set up. What this fund will be is at least three months worth of rent. This should cover if there are unexpected vacancies, as well as some money left in case of emergencies (or maintenance). You don't want to have to tip into your personal finances in order to maintain your property, or if a month or two goes by without any renters, so if you are going this route, please make sure that you have enough float cash to cover.

Some people use a line of credit for an emergency fund. I would recommend against this as a shift in mentality. If you have money saved for your emergencies, it is much more positive than having to borrow money for emergencies. It is another level of freedom that you wouldn't otherwise have. If you lose your job, do you really want to have to pay back a line of credit?

My recommendation to everyone is to open up a Tax Free Savings Account and put $1000 in there (or at least contribute every paycheque until you are there). Then if something bad happens and you need some cash, you will have it. Remember to try to minimize your consumer debt!