You lose your job, your car breaks down or you furnace needs repairs. It’s crucial to a contingency plan in place to cover unforeseen expenses. The last thing you want to do is use your credit card or use other forms of debt. Most financial experts recommend three months to a year’s living expenses in an emergency fund. While it’s a crucial to put some savings aside for a rainy day, does an emergency fund that size really make sense for everyone?
High Interest Debt
Whether you’re carrying a large credit card balance or you’ve borrowed money from a payday loan service, it’s hard to justify having one year’s expenses set aside for a rainy day when you’re most likely paying interest at over 20%. Whether you’re saving $100 per week towards your emergency fund or you’ve put enough money aside to cover a year’s living expenses, your money would go to better use by paying off high-interest debt. Not only does it provide a guaranteed rate of return, you’ll save yourself hundreds in interest.
HELOC or Secured Line of Credit
With prime rate at a historic low (currently 3%), Home Equity Lines of Credit (HELOC) and other Lines of Credit (LOC) are worth considering as alternatives to the traditional savings account emergency fund. If you’re a home owner, it’s a great way to access cash at a low interest rate.
RBC is currently offering a secured LOC at Prime plus 0.5%. It’s a good idea to set up your HELOC or LOC today while you’re in good financial shape – just avoid the temptation to dip into it for unnecessary purchases. This strategy works best for those with pristine credit history and a high cash flow relative to their fixed expenses. If your credit history isn’t so great, overdraft protection on your chequing account is good alternative, although you’ll generally pay a higher interest rate.
High Monthly Income versus Fixed Expenses
A two-income household earning $100,000 annually after taxes, mortgage-free with zero debt who lives frugally, probably doesn’t need a very large emergency fund. In a worst-case scenario they could use their monthly cash surplus.
Steady Part-Time Employment
If your biggest fear is losing your job, having a steady part-time job where you can take on full-time hours is a great way to protect yourself. Even if it’s just a part-time job at the local supermarket, as long as it can cover your monthly fixed expenses (mortgage, utilities and property tax) you’ll be in good shape. If you’ve increased your mortgage payments you can usually scale your fixed expenses until you land a new full-time position.
Students Living at Home
University students living rent-free at home probably don’t need a large emergency fund or if any. What’s the worst that could happen? Your parents could lose their jobs, but they probably (hopefully) have a contingency fund set aside.
Even if your parents are paying your tuition, consider applying for a student loan (if you qualify). It will provide you with interest-free money while attending school. You can always pay it back in full if you don’t need it and not owe any interest. Interest on a student loan is a lot lower than carrying a balance on your credit card.
Non-Registered Account with Liquid Assets
Instead of keeping your rainy day fund in a savings account, an alternative is to keep some of your non-registered investments in liquid investments, such as bonds and preferred shares that can be easily redeemed. Not only will liquid assets help with your asset allocation, you’ll avoid keeping your funds in a savings account earning little interest.
If your biggest fear is job loss, insurance is a great way to protect yourself. Most employers offer group insurance – sufficient disability, critical illness, life and health insurance are very important. If you get sick or pass away, insurance will help cover your family’s monthly expenses. In case of job loss, employment insurance can help to bridge the gap, but it’s likely that it won’t be enough, so it’s advisable to put some savings aside.
You’re a Renter with no spouse or dependents and little assets
If you’re a lifelong renter with no spouse or dependents, what’s the biggest financial disaster that could happen? Usually the biggest worry is home repairs (which you don’t have) or job loss. In case of fire or flooding, it’s a good idea to protect your apartment contents with tenant insurance.
For job loss, it really depends on how stable your career is and how long it will take to find new employment. If your firm is restructuring and you estimate it will take you six months to find new employment, it’s a good idea to have enough money on hand in your savings account to weather the storm.
What is your financial plan in an emergency situation? How much have you put aside?
About the Author: Sean Cooper is a single, 20-something year old, first time home buyer located in Toronto. He has experience in the financial sector as a Pension Analyst, RESP administrator and Income Tax Preparer. He holds a Bachelor of Commerce in business management from Ryerson University. You can read some of his other articles here.
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