An emergency fund is the least sexy of all the financial planning topics. However, knowing that your financial obligations will be covered for a period of time—no matter what happens to your job, health, or personal circumstances—is critical. This is true whether you’re just starting out or already have substantial savings.
What’s an Emergency Fund?
- It should hold 3 – 6 months’ worth of expenses, including debt obligations such as car loans and mortgage payments.
- It must be accessible to both partners in a household.
- It should be held in cash or a near-cash instrument (high-interest savings or money market funds).
Why Don’t More People Have One?
Most clients want their money to be actively invested and generating returns. Few are content to sit on idle cash. As a result, I am often called upon to defend the utility of holding a robust cash reserve. I often have to make a case to clients that having an adequate emergency reserve is important to protecting their standard of living.
Client: “I can always use my line of credit in an emergency.”
Me: In my experience, when you’re faced with an emergency like an illness, injury, unemployment or unforeseen expense, the last thing you want to do is go into debt. I would recommend that you reserve 3 month’s worth of expenses in cash and only tap into your line of credit if the emergency lasts longer than that.
Client: “I have a lot of money in my RRSP, so I don’t need to have an emergency fund.”
Me: RRSP withdrawals are taxed on top of other earnings in the same calendar year. If you’re in a high tax bracket, you’ll pay heavily to access those RRSP funds. Even if you’re in a modest tax bracket, there are withholding taxes which range between 10% and 30%. Bottom line: RRSP assets are a costly way to fund your emergency needs.
Client: “I could always sell some of my investments.”
Me: Unfortunately, only cash maintains a predictable value. Imagine having $10,000 in stocks as your emergency fund in 2008. If you lost your job during the Great Recession, your emergency fund might only be worth $7,000 when you need the money most. Besides, if you think that holding cash is uncomfortable, try being forced to sell an investment at a steep loss!
Client: “My partner has a high-interest savings account that we use for emergencies.”
Me: Then add your name to that account. Remember, even if you share a surname with your partner, the Personal Information Protection and Electronics Documents Act (PIPEDA) will only permit the account holder or guardian of property to access funds or information about an account. An emergency reserve is of no use if you cannot access it to cover expenses.
Emergency Fund Basics: What You Need To Do
- Hold 3 months of cash in a jointly-registered account even if you have executed Powers of Attorney. A joint account will ensure that both partners can easily access the money. Anyone who has faced a true emergency will appreciate the convenience of not having to locate a Power of Attorney or visit a safety deposit box before you can cover the mortgage payment.
- When you negotiate your next mortgage, make sure to establish a secured line of credit equal to at least 3 months of expenses as your second line of defense in case of emergencies.
- Understand what an emergency truly is. An emergency is something that takes your breath away and threatens your health, safety or financial stability. (E.g. Raptors’ tickets are not an emergency.)
- Your emergency fund should never be used for “planned spending”. Clients are often tempted to tap into their emergency reserve to augment a down payment, retirement savings or simply because they need a vacation. Look elsewhere. In a best-case scenario, these funds will never be touched.
The reassurance that a cash cushion gives is worth the opportunity cost of having a bit of idle cash.