The exceptional circumstances in 2020 demonstrated the importance of having a personal emergency fund. The advantage is that it will help you deal with the unexpected, regardless of your financial situation. While it will help you out if you lose your job or are faced with surprise expenses, your emergency fund can also help you achieve your goals, and even save for your retirement. Find out how.
What is an emergency fund? Basically, it’s money that you set aside to help you deal with unexpected expenses. “An emergency fund is what will help you keep calm when you think of one day having to handle an unexpected expense,” asserts Pierre-Éric Lebel, Manager, Development and Sales Support, and Financial Planner at National Bank. “Because these things happen to everyone.”
“Nasty surprises can be caused by a decrease in income, a loss of employment, or a major expense. Maybe there were salary cuts at your workplace, or your water heater broke down, or your pet needs an operation. These are things that you don’t plan for in your budget, nor do they count as semi-regular expenses like vehicle registration fees or any yearly subscription. If you have an emergency fund, you don’t have to go into debt or start penny-pinching to compensate for sudden expenses. Moreover, you’ll be able to stick to your budget. In any case, it won’t stress you out as much,” the expert contends.
“There’s no target number to hit when building your emergency fund. While some people aim for three to six months’ worth of salary, I believe it makes more sense to think in terms of three to six months’ worth of expenses. In some cases, it amounts to about the same thing,” the expert advises. “In 2019, more than half of all households in the country reported living paycheck to paycheck. That’s just another reason why you should have an emergency fund, regardless of how much money you can set aside.”
“Here’s an example: your car breaks down and the mechanic tells you the repairs will cost over $1,500. If you don’t have the money and charge it to your credit card, it’s going to hurt. The interest will pile up and it will throw a wrench in your budget. However, if you already have the money in your emergency fund, the expense won’t have a negative impact on your daily life and you won’t fall into debt.”
“Before building an emergency fund, the first thing you have to do is pay off the debt that’s costing you the most in terms of high interest rates, like credit card balances. Systematic savings is the best way to do that,” Lebel explains. “Get used to paying off a predetermined amount to maintain a balanced budget, which will allow you to keep comfortable.”
“Then, open a savings account if you don’t already have one. The money for your emergency fund shouldn’t sit in your chequing account. Allocate part of your budget to your emergency fund. With each paycheck, or every month, make sure that the amount you wrote down in your budget is transferred from your chequing account to your savings account. You can even program it so it’s done automatically, without even thinking about it.”
“The money in your emergency fund has to be liquid,” Lebel cautions. “You have to be able to withdraw the money easily, automatically, and all at once. Remember that the purpose of an emergency fund is to be able to quickly handle the unexpected. Because of that, I wouldn’t recommend a product like guaranteed investment certificates, since those have limited terms. Instead, I would go with a high-interest savings account, which is a good tool for building an emergency fund. There are no monthly fees and there’s no limit on the number of transactions between your accounts.”
“You could also create an emergency fund in a tax-free savings account (TFSA). But keep in mind that there’s a contribution ceiling for TFSAs. In 2020, the maximum was $6,000.”
“Another interesting route is to apply for a line of credit at your financial institution. This strategy is actually recognized by the Institut québécois de planification financière. With the help of your advisor, choose a product with features that meet your needs. Make sure that the money you borrow corresponds to no more than three to six months of expenses. You won’t have to reimburse the capital or pay any interest if you don’t use the money and the account balance stays at zero. With that as your emergency fund, you’ll be free to put your savings towards long-term goals, like your retirement. But be careful: this is still a credit solution. If you use it, pay off the amount you borrowed as soon as possible.”
“Some people are surprised to learn that emergency funds have more than just one use,” Lebel adds. “Once you’ve saved up that three to six months’ worth of expenses, you’ll have developed excellent saving habits. Keep it up by saving for goals that are important to you. Whether you want to plan a quick getaway or buy a new car, you’ll be able to save a nice sum of money without sacrificing too much nor having to cut down your budget. Of course, be careful not to dip into the money you’ve set aside in your emergency fund.”
If you’ve collected the Canadian Emergency Response Benefit (CERB), be aware that this is taxable income. That means you’ll have to declare it in your income tax. You’ll probably have to pay tax on these benefits. Plan ahead now by building up your emergency fund to avoid any financial hardships this may cause. Discover more advice about managing your personal finances during COVID-19.
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