Invest It Wisely

Maximizing your EV in life

5 Reasons to Have an Emergency Fund

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Vault in Calaceite. Source: http://commons.wikimedia.org/wiki/File:Vault_in_in_Calaceite.jpgPreparing for the unexpected

It is impossible to expect the unexpected, because when you are expecting something it fails to be unexpected and something else you weren’t expecting still manages to trip you up. So rather than trying to second guess life, stop expecting the unexpected and simply put a contingency plan in place for when you are next thrown a curve ball. In this way you’re prepared for the worst, rather than sitting around in a state of dread, waiting for it to happen.

An emergency savings fund is the best way to prepare yourself for the dramas, expenses and surprises which are life. Even if you’re thinking your life isn’t that dramatic, your job is secure and you don’t need an emergency fund, here are five real reasons why you do.

1 – The best things in life are free

And the worst things in life are very expensive – losing your job, being injured, having a car accident or having to care for a sick child. However, whether you don’t have income protection, the situation doesn’t qualify or seems too insignificant to claim for, several thousand dollars in an emergency fund can come to the rescue.

At the same time, emergencies are not always related to losing time at work. You may have a tyre blowout and have to spend several hundred dollars to replace that tyre. Or you may experience a rise in your cost of living if interest rates go up and your mortgage repayments go up – that certainly isn’t something you can claim on your income protection insurance but it can pose a real emergency for your budget.

Expenses and disasters can crop up at anytime and happen to everyone. Emergency expenses are a part of everyone’s lives, to different degrees and being prepared for the worst allows you to enjoy the best.

[Kevin] How much should you put in the emergency fund? Three months of basic expenses? Six months? I also agree that some money should be kept in highly liquid cash, and beyond that point one should also look at paying down debt or investing.

2 – You’re more likely to accumulate debt without one

Debt in itself can be an emergency, and commitments to mounting credit card balances and numerous personal loans are stopping you being financially free and secure. As a result, you want to do everything you can to avoid getting into more debt than you can afford, however, it is proven that those people who don’t have an emergency fund are more likely to accumulate debt.

This is because you don’t have the financial safety net behind you and you don’t have the savings and financially responsible skills you need to be able to plan for an emergency and avert the potentially disastrous effects of an unexpected expense. If being able to avoid more bad debt was as simple as setting up a savings plan, what is stopping you?

You think you can’t afford to spare the funds. This is the most common reason people put off building an emergency fund but the truth is that the times you think you can’t afford an emergency savings account are the times you can’t afford not to have one. Think about it, if you’re struggling now, how will you be able to deal with an unexpected expense?

This is where you would normally turn to your credit card to ease the immediate pressure, but this too simply sets you up for another emergency expense down the track as the interest on your card compounds and your monthly payment needs to be made.

[Kevin] This is perhaps true. One has to consider the opportunity costs of not investing or paying down debt as well, but the safer route is also the route with less variance and more security. For some people, an emergency fund means the difference between feeling secure and being able to sleep at night, and worrying about whether one is prepared for what may come ahead. This will play a big part in determining what amount is right for you.

3 – Encourages other good habits

Having an emergency fund can make your more financially responsible in other aspects of your life. In order to save you have to reduce your debts and curb your spending on luxury items to free up funds in your budget to be deposited into savings.

As a result, you’re not only prepared for the worst if it happens, you are also sticking to a budget, controlling your debt levels and living within your means and spending less than you earn is an important lesson for everyone to master.

[Kevin] I like this point. It takes a bit of discipline and practice to start saving up an emergency fund, and this will help to instill good habits which will help you down the road and help you to make good decisions, such as when deciding whether it’s a good idea to cosign a loan.

4 – You could be more at risk than your neighbour

The amount you need in your emergency savings account can also be cause for emergency if you are relying on savings which are not substantial enough to see you through. Most financial experts suggest that you need enough money to cover all of your living expenses for between three and six months. So how do you know you’ve got the right amount?

The answer comes down to your individual situation, not how much your sister, neighbor or co-worker has saved. For example, if you have a career in an industry which is going to see an ongoing demand, and you have strong job security, covering three months’ of expenses may be enough for you. However, if you are in a more demanding career, in a managerial or executive position, or you and your partner both work at the same company, you may need enough to cover expenses for nine months to a year.

Saving such an amount can seem like a daunting task, however, preparation and planning are the most important things when it comes to outlasting tough financial times, and achieving financial security.

[Kevin] Agreed; the more variable the income, the more buffer is needed. Reducing expenses and maintaining a healthy gap between income and expenses also helps a lot.

5 – Your investments and assets are not savings

If you think you can rely on your investments and assets to cover the costs in an emergency you may need to think twice. Investments can be risky and if you put store in the belief that your investments can cover your emergencies, you may not have as much money as you thought. Plus investments can’t always be easily accessed, for example an investment property is not readily turned into cash if you’re out of work and shares and term deposits can charge significant fees for early access.

While you’re considering the assets which can see you through tough times, consider what liquidating those assets really means. It is a short term solution to a longer term problem, and what does it really achieve to sell the house in order to pay the mortgage?

Instead have your savings in an online high interest savings account. In this way your cash can earn interest, you can easily make deposits, but you don’t have access through an ATM or credit card. Your cash remains at call in your account and will at most take two or three days to access as it is transferred to your transaction account. If you want to be covered for every eventuality, you may even consider keeping the bulk of your emergency fund in your online savings account, and a few hundred dollars stashed at home for immediate access.

[Kevin] I think that Alban makes a great point regarding the fallibility of relying on investments as a replacement for highly liquid cash or cash equivalents. One should have a spread of investments across different asset classes and different levels of liquidity. Just as you shouldn’t put all of your eggs in one basket, nor all of your money in a single stock, I think it’s a good idea to have some investments in a retirement savings plan, some in a tax-free savings account, and some in unregistered accounts. One should also have cash at home and at the bank, and ideally one would also have equity in their home, if they own a home.

In addition to cash at home and in the bank as part of one’s emergency fund, I also believe that precious metals have a role to play in one’s overall portfolio, not only as stored in easily-liquidated online accounts (whether secured certificates or unsecured pool accounts), but also as physical bullion. While bullion is less liquid than cash and pool accounts and comes with higher transaction costs, bullion can also add additional diversification and insurance to one’s portfolio.

 

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Comments

  1. Kevin, you know that I’m a big fan of emergency funds for the aforementioned reasons. It’s a powerful tool and can dramatically increase your peace by decreasing your risk. Sure you can have other assets available to you, but that doesn’t diminish the intrinsic value of having an emergency fund designated just for a rainy day.

    • What I love about the PF blogosphere is that we can each explore different facets of these subjects. One guy can make the case for a large emergency fund, and another guy can mention the benefits of paying down debt, while a third can mention keeping some money in highly liquid funds instead of plain cash. For example, you can keep some money in GICs which can be redeemed in an emergency with only an interest-rate penalty (so if there’s no emergency, you get 4% for example, and if there is, then you get 3% instead). While having some fat on the side is important as a reserve, each personal situation is different, and therefore the solutions will be different, too.

      • Kevin,
        That’s a good point. My concern is that someone may be under the illusion that 4% on a small amount of money (i.e. 3-6 month expenses for many people) after taxes is really going to change his or her life. It’s certainly better than the horribly low 1-2% available with many online money market accounts. I have just found that many people who keep their EF in things that could be construed as investment vehicles have a harder time cashing them out in a real emergency. In fact, some will instead go into debt to avoid “messing up” their investments.

        • I think that’s why these recommendations need to be personalized. With those types of people the recommendations would be different than, say, someone who would not see a GIC as an investment but rather as a way to park cash with a slightly better return. I guess that’s why they call it personal finance though 😉

          • Kevin, I absolutely agree with you again, which is why it is so difficult to espouse only one path. I love the discuss of the pros and cons of each plan because they all do have important limitations that must be addressed on an individual basis.

  2. Emergency funds are a really good idea. I like the idea of 1 year. Yes, that’s more than what most “experts” say, but I suppose it’s a level of personal comfort that’s involved in that choice. Call it the “sleep well at night” factor.

    The thing about emergency funds is that it’s important to make sure it’s truly for emergencies. Now, along those lines, let’s remember that we have to expect the unexpected – at least to some degree. Whether it’s the tire that blows out, or the ticket we get for accidentally going through a red light, or the respiratory infection we get that seemingly comes out of nowhere- these things happen. We don’t what they will be, but they will happen.

    Think of home repairs this way too. We may not exactly know what will happen, but something will. Maybe there will be a plumbing issue that we didn’t foresee. Maybe a tree will fall. If you have a condo, maybe there will be an unexpected assessment. Something will happen.

    These aren’t emergencies, but fall into the category of the “small yet unexpected that we expect to happen.” Some out of our control (tree falling), some due to the personal idiot factor (running red light). Stuff happens. For such items, I think it’s smart to account for them in our budget, maybe as a separate item based on a % of income. 1%?

    The emergencies might be for real major unexpected issues. Maybe a car wreck that requires time out of work, uncompensated. Maybe your company is sold and you unexpectedly get laid off in a tough market. Bigger things like that.

    There’s a fine line here, no question, and some of this interpretation might just be individual-specific. But saving for true emergencies is vital, I totally agree with that.

    • I think this is an important point. So many people focus on the how and how much that we forget to look at what we can do to avoid having to dip into an emergency fund to begin with. By planning ahead, we can either plan for or neutralize some of the “unexpected” threats in life.

      In the same vein, I don’t think using a rise in your mortgage interest rate is a valid example of an “emergency”; if you have an adjustable mortgage, guess what that interest rate is bound to do eventually? How is that unforeseen?

      • How do adjustable rate mortgages work in the US? I think this is a valid concern for Canadian variable rate mortgages, but IMO it is wise and advisable to plan for at least a 3% rate hike in this current environment of low interest rates, and to plan for total carrying costs at 33% of net income or less so that you don’t get screwed by higher rates! Thanks for mentioning that point.

    • Hey Squirrelers,

      Good point. There are always unexpected contingencies that can come up. In addition to an emergency fund, I highly recommend that one keep a healthy gap between income and expenses. IMO this adds more security than an emergency fund does.

      The optimum size for an emergency fund will also depend on many factors, such as age, stability of income, insurance, etc…. For me, one year is too large. This would probably comprise more than 33% of my overall net worth. I’m still very young and I’d rather take advantage of tax savings when investing in retirement, use the money for a down payment, etc… and I also have full insurance on my car, a warranty on the most expensive stuff, I have life insurance, and we get EI here, so for me, two to three months is best.

  3. Bein’ self-employed i would not sleep a wink if i didn’t have an emergency fund. Wait, i don’t sleep much and i have an emergency fund……well, i guess that’s just the problem with being self-employed!

    • As a self-employed person I think I’d definitely want a much bigger buffer! In that case then maybe 1 year or more would be good to have around.

  4. Good post Kevin. I’m definitely a big fan of emergency funds. As much as possible, my wife and I try to keep two months salary tucked away for some very bad, windy, rainy days 🙂

  5. I think the question of where one should put an emergency fund is also highly dependent on one’s personality as well. I know for me, I built and spent my emergency fund about a dozen times before I found something that worked for me…It was savings bonds because I literally couldn’t cash them right away and once they were bought it was mentally like the money was gone forever. I haven’t touched them since. My money market on the other hand still gets emptied on a regular basis. I like the idea of having very liquid assets and the bonds are now, but to get over the savings hump, I really needed something that had a penalty if I were tempted to touch it.

    I liked this post. It made me think.

    • At ING Canada there is the option of guaranteed certificates of deposit. They have a fixed interest rate, but if you touch the funds before the certificate expires, then you get about half the interest. I think this is a fair way of doing things that does not expose you to unusual penalties, but still rewards you for not touching the money.

    • Haha…. true. I find even within the choir there are many diverse opinions, though. For example I personally place more emphasis on the income/expense gap and, at least for me personally, I feel that 2-3 months is fine.

  7. Thanks for sharing! I think it is really important for all of us to have an emergency fund. It is a must, I believe.

  8. On my climb out of the depths of hell (or debt as some people call it) I found that the world changed colour from dismal grey to a shiny optimistic warm orange glow once I established that first $1k emergency. Up to $3k now and will be adding another $2k in 2 weeks…. It’s an emergency / debt pay off fund but it’s encouraged all sorts of other good things in my financial habits as you said.

    • Wow, haha, that’s a colourful way of stating it. I felt the same way when I dragged myself out of debt and started accumulating savings for the first time and I could actually watch it grow.

  9. I think emergency funds are super important to have. Something easily accessible. You never know when that drying machine or washer will give out etc.

    Always prepare for the unexpected!

  10. This is so true. People without emergency fund go into debt almost immediately. In fact, saving up for emergency encourages self-discipline and prioritization. Great post!

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