In previous posts, I’ve mentioned that putting money aside for an emergency fund should be a priority in your financial goals (read Step 5 in 7 Steps for Dealing With Financial Stress). The term “emergency fund” brings to mind money saved for severe, unexpected expenses such as losing your job, or experiencing an unfortunate injury or illness that prevents you from being able to work.
I prefer to view an emergency fund as money you’ve set aside for life’s unplanned, expensive events. Yes, this would include losing your job or being unable to work because of an accident or illness. But, this also includes life events that may not be planned for, but are inevitable in the long run.
Unscheduled Events
During my career as an investment advisor, I had a client who had worked for many years on oil and gas drilling rigs. He often described how mechanical breakdowns, and other unforeseen problems would delay or halt drilling for a while. My client referred to these setbacks as “unscheduled events”.
I’ve always thought that term aptly describes the curve balls life invariably throws you. These unpleasant surprises cause not only mental frustration, but also strain your bank account. Unscheduled events, (just like mechanical breakdowns on a drilling rig) are bound to happen. Consider these realities:
If you own a pet, sooner or later you will experience an expensive vet bill.
If you own a car, eventually you will need some costly repairs.
If you own a home, your furnace, water heater, or a major appliance will konk out on you.
If you have children, the number of costly surprise expenses you can experience is unquantifiable!
I’m sure you get the picture. Having an emergency fund is not just for true emergencies; it’s there to provide you with security and liquidity for the inevitable unscheduled events of life.
Emotionally, these events feel like a crisis when they happen. Practically speaking, we should expect that they will happen even if we can’t predict when. Having money set aside to prepare for unscheduled events will take much of the sting out of the occurrence and make them seem less catastrophic.
Emergency Fund vs. Debt
Certain financial advisors suggest setting up an emergency fund is an inefficient use of savings. Their line of reasoning is that in the current environment of low interest rates, setting aside 3 to 6 months worth of income in a liquid investment won’t earn you very much money. Rather, they argue, you should put all of your money to work in investments more suited to longer-term and higher growth, and use debt to pay for any short-term emergencies with borrowing costs being at historical lows.
On paper, this argument has some logic. Where I disagree with this train of thought is that far too many people already carry more debt than they should. So many people are maxed out or close to it. For those who do not qualify for lower interest debt such as a Home Equity Line of Credit, they’re only debt source for funding emergencies may be a credit card. With credit card interest rates typically in the high teens (or higher), this destroys the idea of trying to eek out a better return on your investments and using low cost debt for emergencies.
My suggestion is don’t try to be fancy with your emergency fund. Keep it simple. Start by putting money into a separate savings account. As the dollars accumulate, you can consider putting the low risk, highly liquid securities (meaning you can cash out quickly and at any time). This would be investments like mutual funds or exchange-traded funds that invest in money market securities. You could also consider cashable term deposits. Your bank, financial planner, or investment advisor can offer specific recommendations in this regard.
How much should I set aside?
The first step to figuring out how much you need in your Emergency Fund is to calculate what your monthly expenses are. If you’ve worked through my Personal Cash Flow worksheets, you will know what it costs you to live each month (if not, you can find them here).
Most financial planners suggest the rule of thumb of having 3 months of living expenses set aside for unscheduled events. Like most rules of thumb, it’s a very general guideline and may not be enough for you. Here are a few things to consider when deciding how much to save:
The line of work you’re in — Are you employed in a position with a higher than average probability for layoffs in poor economic cycles? How long could it take to get another job in a downturn? Would you need to relocate to find work if you lose your job?
The age and quality of your home — What is the likelihood of needing expensive repairs for your home? When was the roof last shingled? How old is the furnace and hot water heater, and major appliances?
The size of your family — How many children do you have? Will any of them be needing glasses, braces, or other costly medical help? Do they participate in pricey extra-curricular activities you’d want to maintain no matter what?
The point is, only you can determine how much is sufficient for an emergency fund. I would say three months of living expenses is a minimum you should shoot for and 6 months would be preferable.
Saving 3 to 6 months of expenses may seem like a daunting task, but if necessary begin by setting a goal to save one paycheque worth of money. Be sure to set a time frame for your goal. Set up automatic transfers into your emergency account on your paydays so you don’t have to think about it. You can accelerate your savings by selling your unwanted “stuff” in your house on eBay or kijiji, or having a garage sale and depositing the proceeds into your emergency fund account. Having even one extra paycheque worth of money tucked away will give you a sense of greater security, and make it easier to keep on saving until you save 3 – 6 months of expenses.
If you’re retired and have a sizeable nest egg tucked away, you may not see the same urgency for an emergency fund. Nonetheless, I encourage you to invest 3 to 6 months of living expenses in secure, liquid securities for peace-of-mind when those unscheduled events pop up. In fact, you may want to consider having an even larger amount in conservative investments to allow you to sleep well at night when your other, more volatile investments are behaving like bratty children.
Speaking of children, one of the best lessons you can teach your kids is to prepare for life’s unscheduled events by saving money in an emergency fund. Getting them to prepare for common unpleasant surprises decreases the likelihood they’ll need to come to you for money when their car breaks down or any other inevitable event occurs.
