Do you really need an Emergency Fund?

By Anita Bruinsma, CFA

Clarity Personal Finance

One of the most agreed-upon financial planning concepts is the importance of an emergency fund. Having quick access to money to pay for an unexpected expense or job loss can prevent unwanted credit card debt and can lower stress levels.

Not everyone is on board though. Some people feel that keeping money in cash instead of investing it means you’re sacrificing too much potential growth. This might be a particularly true for people who are targeting financial freedom. Since investing is an important component of reaching financial goals, it’s understandable that you don’t want to drag down your overall rate of return by holding cash.

Having access to money for unexpected expenses, though, is important for pretty much everyone. So do you need an emergency fund and if you do, how much should it be?

Do you need an emergency fund?

If you have a home equity line of credit (HELOC), you might not need funds sitting in a savings account. Whether it’s a good idea to depend on your HELOC as an emergency fund depends on two main factors: if you had to borrow from it, how long would it take you to pay if off and what is the rate of interest you’re paying?

Generally, as long as the rate of interest on the line of credit is below what you could expect to earn in the stock market, and assuming you’re able to pay down the line of credit within a reasonable time period, then using your line of credit isn’t a bad idea. The key is to make sure you are disciplined in paying down the line of credit quickly, otherwise the interest cost will outweigh what you could earn in the market.

How much do you need?

For those who don’t have a HELOC or who prefer to have a safety net in cash, determining the right amount of money to keep in an easy-to-access, low-return account is important.

There are really two kinds of emergency funds: one that will pay your expenses if you lose your job or can’t work for a period of time, and one that will pay for the large, unpredictable expenses that crop up in everyday life.

The job loss emergency fund

Job loss can mean you were laid off or that you can’t work due to illness, an accident, or a personal/family crisis. You might have heard the standard advice that says you need 3-6 months’ worth of living expense to protect against a job loss. Like all personal finance shortcuts, this isn’t necessarily helpful. How much you need in an emergency fund is highly dependent on your situation.

Here are the main factors that influence how much you should have set aside in your job loss emergency fund:

1. Do you have job stability? If your industry is known for sudden layoffs or if your role might be considered non-essential to an organization, you have a higher risk of losing your job and it might take you longer to find a new one. It would be wise to have a bigger cushion than someone who works in a stable industry or performs an essential role.

2. Do you have disability insurance? If you have an accident or get really sick, you’ll receive some kind of payment while you have to take time off work. It won’t necessarily be enough but it will help and you’ll need a smaller emergency fund. If you expect to receive no pay if you need to take time off work, you need a bigger emergency fund.  

3. What kind of lifestyle do you want to maintain? If you are laid off, you’ll need to pare back your spending. But to what extent? What do you consider to be “essential”? Are the kids’ swimming lessons essential? What about your gym membership? Understanding what essential means to you will help you decide how much to set aside.

4. Do you have a partner or spouse? If you have a partner or spouse with whom you share the financial responsibilities of running a household and they are employed, would they be able to cover the essentials if you lost your job? How would your lifestyle be impacted? What is their job stability like? Do they work in the same industry as you do? If so, there might be a higher risk of both of you being laid off at the same time.

5. Do you have savings in a TFSA or a non-registered account? If all of your money is in RRSPs or your pension, you don’t have any good options for withdrawing money in an emergency. However, you could choose to rely on your TFSA or non-registered funds for a portion of your needs.

The large expense emergency fund

For your large expense emergency fund, the amount you want to have available depends on how many opportunities for unexpected expenses you are exposed to and what other resources you could draw on.

1. Are you a homeowner? Owning a home can require large outlays for repairs and maintenance. A few years ago my furnace broke down and I spent $10,000 on a new one (plus adding air conditioning). Need a new washing machine? Count on $1,400. Racoons nesting in your roof? $1,000. Deck rotting? Leak in your bathroom? You get the idea. This list goes on and on. And that’s not to mention improvements like painting, upgrading the bathroom, and replacing the cracked concrete walkway.

2. Do you have dependents? Children are the primary dependents in our lives and they present a huge opportunity for unexpected expenses. Braces, glasses, stolen bike, malfunctioning laptop, lost phone, therapy or counseling … need I go on? Or maybe you have parents who wouldn’t be able to afford things like homecare if they suffer a stroke, or renovations to adapt their house due to mobility issues. Having people counting on you to pay for their needs makes a big difference.

3. Do you own a car? We all hate that sickening feeling in our stomach when the mechanic gives us the estimate to fix the car. The feeling is worse if it stays on your credit card for months on end. Unless you have a very new car, expect that you could be hit with a big bill at a moment’s notice.

4. Do you have a pet? Vet bills are another stressful event and they can add up quickly, especially if your cat or dog gets injured or sick. Plan for several thousands of dollars should your furry baby get in serious trouble.

5. Do you have a cottage or other property? Sometimes bad things happen at the cottage – broken windows, downed trees, burst pipes, a runaway dock. It can be hard to know what might happen next, especially if you rent it out.

6. Do you have savings in a TFSA or a non-registered account? Money in these accounts can be accessed in a dire emergency without penalty.

How much?

There’s no perfect number when it comes to how much you should set aside for emergencies. Everyone’s life situation is unique and, as always when it comes to money, emotions play a role too.

When determining your job loss fund, here’s one approach you can take:

1. Create a list of all your expenses to know exactly how much your life costs. Then, go line by line and decide which items you will would be willing to eliminate or reduce if you lost your job and create a “just lost my job” budget.
2. Subtract your spouse’s monthly income (after tax and deductions) from the “just lost my job” budget amount.
3. If there is a deficit, multiply it by the number of months you estimate it will take you to find another job.
4. If you have money in your TFSA or non-registered account that you’re willing to use, incorporate this into your plan, lowering the amount of your emergency fund.

Here is an example.

For your large expense emergency amount, consider brainstorming the major emergency-style expenses that could come up and estimate the cost. Choose the most expensive one or if you’re particularly nervous, choose two. This is your emergency fund

What do to with it

Money that you might need on short notice should not be invested in stock market. Instead, you’ll want to find the highest interest rate-paying vehicle for holding your emergency money. Consider holding a portion in an easy-to-access savings account and a portion in something slightly less accessible, but equally safe.

Savings account: For the large, unusual expenses fund, set the money aside in a savings account. For the layoff emergency fund, you won’t need the money all at once – it will be required in a steady stream over time. Consider leaving two months’ worth of expenses in a savings account and investing the rest in something that can earn you more.

Options for other emergency savings: For the money you might not need immediately – the rest of the “job-loss” fund and extra “large expense” money – there are a few options.

1. High interest savings ETFs: These ETFs invest in high interest savings accounts of Canadian banks. The interest rate is attractive right now but will fluctuate. You can easily take the money out of the ETF, but you’ll need to place a trade and give it a day or so to be accessible to withdraw depending on where your account is.
2. Short-term GICS: You can buy short-term guaranteed investment certificates that mature in as few as 30 days. This would be appropriate for the job-loss fund, since you can use the funds in your savings account for the first month or two while you wait for the GIC to mature.
3. Cashable GICs: GICs are usually non-cashable, meaning you can’t access the money until they mature. Cashable GICs are exactly what they sound like: you can take the money before maturity. This can be a good option, just be aware that the rate on these GICs will be lower than a regular GIC.

Setting aside an emergency fund is one of the foundations of a financial plan. To optimize your investment returns while doing adequate contingency planning, it’s worth taking the time to put a plan in place.

Anita Bruinsma, CFA, has 25 years of experience in the financial industry. As a long-time investor, Anita is passionate about demystifying investing to make is accessible to more people. After a long and satisfying career in the world of banking and wealth management, including 15 years managing mutual funds with a Canadian bank, Anita started Clarity Personal Finance, and now helps people learn to better manage their finances, including how to invest for themselves.