Life is chock full of surprises.
Sometimes life’s surprises are pleasant.
Say you win tickets to see your favourite singer perform at a live concert. Or you get bumped up to a first-class seat when you had paid for a coach plane or train ticket.
Other times, however, life’s surprises come with a price tag.
The price may be negligible (thus quickly forgotten), or it may be hefty and throw a wrench into your financial plans.
And by definition, surprises, pleasant or otherwise, come without giving prior notice or warning.
Such are the instances when an emergency fund steps in.
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What is an Emergency Fund?
An emergency fund (or a rainy day fund) is money set aside to cover any financial surprises that may come your way.
It is an essential part of personal money management, and every adult should have one.
Having a rainy day fund turns what may have otherwise been a financial blow into a mere inconvenience.
It also provides priceless peace of mind during both stable and unstable economic times.
Let’s dig deeper into some of the common reasons that may call for a rainy day fund.
What type of expense is an emergency?
1. Job Loss
Most people are dependent on their jobs for their livelihoods. It is their sole source of income.
Recent global events, the 2020 coronavirus pandemic, have demonstrated that things can dramatically change in a moments notice. Widespread lockdowns have caused businesses to shut down and many people to go out of work.
Having emergency funds when facing a job loss allows you to weather the financial storm with minimal panic until you find another job.
2. Medical Issues
Even where healthcare is readily available in countries such as Canada, not all expenses are covered. Some costs, such as medication, vision care, dental care, hospital rooms, etc. may only be partially covered.
In countries where publicly funded healthcare is not as readily available, a medical emergency could be financially crippling.
In any case, an emergency fund can cover unexpected medical bills and reduce the financial stress in such a situation.
3. Car Repairs
While regular car maintenance (such as oil change or fluid top-up) is no surprise, some major car expenses can seemingly appear out of thin air.
Issues with car transmission or, worse, engine damage can cost thousands of dollars to address.
Further, depending on where you live, it may not be possible to function without a car. Thus, you may need to shell out lots of cash to get your vehicle up and running again.
And an emergency fund could save the day in such a situation.
4. Unexpected Pregnancy
According to a 2011 CDC report, about 45% of pregnancies are unintended.
While children are indeed a miracle and joy, they come with financial obligations.
Costs related to pregnancies include prenatal care to post-delivery childcare.
A rainy day fund will help cover the immediate costs associated with an unexpected pregnancy.
Further, as some childcare costs can be unique and unpredictable, it is all the more reason to build an emergency fund.
5. Unexpected Tax Bills
When filing taxes, no one likes the unpleasant surprise of owing taxes instead of receiving a refund!
However, sometimes you do end up owing the government some taxes.
You may owe taxes if you withdraw from an RRSP and your financial institution withholds an insufficient amount for taxes.
It could also happen if you change jobs mid-year.
Your new employer may exempt the first portion of your income from taxes. However, your previous employer may have already exempted a part of your earnings from taxes, and thus, you end up owing taxes.
You could also owe taxes if you are self-employed as no one withholds taxes on your behalf.
Whatever the reason for owing the taxman, an emergency fund softens the blow of such unpleasant news at tax filing.
6. Rent Increases
You can be subject to rent increases if you live in an area not under rent control.
Even with adequate notice from the landlord, rent increases could throw you off your budget.
7. Home Repairs
If you own your home, you are responsible for all the repairs and maintenance costs.
The costs could range from a few dollars to change light bulbs to thousands of dollars for roof or pipe repair.
Owning a home can be quite costly, and a rainy day fund can help you out tremendously.
8. Identity Theft
Identity theft happens when your details are stolen and used to gain access to your financial accounts fraudulently.
More often than not, identity thieves will go on a spending spree on your account.
After speaking with your financial institution, identity theft issues eventually get resolved.
However, you may have a few days where all your accounts are frozen.
Because of such situations, it is advisable to keep about $1,000 of your funds at home in cash.
9. Dropping your phone or laptop (in water)
It is nearly impossible to function without phones, laptops, or tablets in today’s digital age.
If you’re dependent on these devices for work or school, it constitutes an emergency should they become compromised in any way.
Funds set aside for a rainy day such as this could help you get back on track with little to no downtime.
10. Reduces the risk of taking on high-interest debt and becoming dependent on credit
Without funds set aside for emergencies, you will likely take on debt to cater to the immediate needs.
Depending on the emergency’s nature, it could take a long time to repay such debt or, worse, get into a never-ending debt cycle.
What type of expense is not an emergency?
What constitutes an emergency will differ from person to person and will depend on various factors.
Generally, though, during stable economic times, routine expenses should not be classified as an emergency. Recurring costs may include rent, mortgage payments, groceries, transportation, utilities, childcare, etc.
If you routinely have trouble paying your bills, even with a stable income, carefully re-examine your budget and make necessary adjustments.
To assess whether a situation is an emergency, it must:
- Hinder your ability to stay safe, earn an income or carry on with your everyday lifestyle, if not addressed
- Be urgent in that you cannot take a step back from the situation and plan for it later
When should you start an emergency fund?
The best time to start setting up a rainy day fund is as soon as you leave your parents’ care.
In other words, all adults should have an emergency fund.
But alas, life is often less than ideal!
So the next best time to start an emergency fund is today.
The key is to start putting aside money bit by bit each month. With consistency and discipline, you’ll soon find your emergency fund fully funded.
How much money should you have in your emergency fund?
As a rule of thumb, financial experts advise that you should have at least 3 to 6 months’ worth of living expenses. Depending on various factors, the ideal amount could be 12 months’ worth of living expenses.
Factors that may influence how many months to save up for may include:
- Number of dependents. Consider higher savings for an increased number of dependents.
- Sources of income. The more sources of income you have, the lower the amount of savings would be required. For instance, a dual-income family may need a smaller emergency fund than a single income family.
- Job stability. Consider increasing your savings for less stable jobs (e.g., seasonal jobs, commission-based roles, etc.) or locations where suitable employment is not readily available.
The most effective way to determine the amount you need is by reviewing your budget. Take into account only the essential expenses that have to be covered each month.
Sum up all the monthly expenses and multiply by 3 or 6 (or whichever number of months you are saving up for). This lump sum is the amount you should aim to have in your emergency fund.
Should you have to dip into these funds, replace the amount used as quickly as possible.
Should you pay off debt before you start an emergency fund?
Whether to pay off debt largely depends on the type of debt that you have.
If you have high-interest debt, such as credit card balances, it is advisable only to set up a starter emergency fund and then tackle debt first.
A starter emergency fund could range from $1,000 to $5,000, individual situation dependent.
Credit card interest fees could typically run up as high as 24.99%.
In some people’s eyes, such high-interest rates may constitute an emergency in and of themselves!
Is $1,000 enough for an emergency fund?
A car brake line repair could cost about $1,000, and many common house repairs could often cost north of $1,000. This amount is not sufficient in most major cities to cover a month’s rent for a 1-bedroom apartment.
$1,000 is not enough for an emergency fund.
However, $1,000 is better than nothing at all, and it is a good starting point.
After paying off all high-interest debt, the next immediate cause of action would be to fully fund your rainy day savings.
How to build an emergency fund
Building 3 to 6 (and sometimes up to 12) months’ worth of living expense is no small feat.
It may seem just daunting.
But fret not, Rome was not built in a day.
It may take a while to fund a rainy day savings fully.
Here are some steps to help you build your emergency fund:
- Determine your lump sum amount. As described earlier, sum your essential expenses and multiply by 3 (or the number most appropriate for you) months’ worth of living expenses.
- Reduce your expenses as much as possible. Have a thorough review of your budget and cut out any unnecessary costs. That daily Starbucks run, perhaps?
- Find or start a side hustle. Making extra money online or offline can significantly boost your savings rate.
- Start small. No amount that is too small. Whatever you can put aside each month will do. As time goes on, you’ll find ways to increase your savings rate.
- Stash your windfalls. Any extra money that comes your way should be put away in savings. Windfalls may include money saved by cutting down costs, side hustle income, tax returns, bonuses, or pay raises.
- Set it and forget it. Automating your savings makes it easy and reduces the chances of talking yourself out of saving in a particular month.
Where should you put your emergency fund money?
It is important to note that an emergency fund is not an investment.
You can think of these funds as your self-funded insurance. As such, they should be easily accessible when the need arises.
However, they should be kept separate from your regular checking and savings money to avoid mix-ups.
Some people may find it best to park these funds in a different bank altogether.
Below are some easily accessible accounts to consider for parking your rainy day funds.
- High-Interest Savings Account (HISA): Offers a higher interest rate than a regular checking or savings account. Online banks tend to have the highest rates. While not intended to be an investment vehicle, earning interest on your emergency fund is a welcome bonus.
- Money Market Account (MMA): A type of bank account that also provides a higher interest rate than a regular savings account. They usually have limited transactions and minimum balance requirements. These two features further make them ideal for rainy day funds.
- Certificate of Deposit (CD): A financial product offered by most banks and credit unions. They provide a higher interest than both HISAs and MMAs. However, deposits cannot be withdrawn for a predetermined period. You can get around this by opening multiple CDs with different maturity dates. In this way, you can keep a certain amount available at all times.
Overfunding emergency savings
Yes, there is such a thing. While the more common situation is to underfund, it is also quite possible to overfund your emergency savings.
This overfunding phenomenon is most common:
- When people are generally risk-averse and typically stay away from investing. These people will tend to hold a lot of cash. Find out why you should start investing sooner than later here.
- Overfunding could also happen when non-essential expenses are mis-categorized as essential. In case of an emergency, expenses such as gym memberships, TV cable, dining out and takeout, etc. can be pared down. Necessary expenses are the bare minimum costs needed to keep the lights on and put food on the table.
While HISAs, MMAs, and CDs all offer some interest, it can hardly keep up with inflation.
In the current low-interest environment, the best rates in the market are around 1.50%.
Overfunding your rainy-day savings could mean forfeiting higher returns in various other investment instruments.
If you enjoyed this article or have any questions, please leave them in the comment section below! I’d love to hear from you! Also, please feel free to share this with anyone that may benefit from it.
“The best time to plant a tree was twenty years ago. The second best time is now.” ~ Chinese Proverb
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