Emergency Fund: Does Everyone Really Need One?

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.

Adequate Self-Insurance

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 AuthorSean 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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Sean Cooper

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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alex
8 years ago

Further support for the “RRSP as Emergency Fund” school of thought.

http://business.financialpost.com/2012/11/24/when-withdrawing-money-from-your-rrsp-makes-sense/

Geoff
8 years ago

We consider our prepayments into our mortgage as our emergency fund. Rather than sticking with a 25 year amortization and making only those payments + saving the difference, we just shovel an extra $1000 each month into our mortgage, which accumulates in a ‘mortgage cash account’ (not all mortgages feature this fyi).

We can then if necessary just transfer some or all of that balance into our chequing account, and then our mortgage inflates again to what it would be – keeping our original 25 year amortization. We currently have a mortgage at 2.99%, and we’d at best get 2% on our savings, so I think it’s a good plan. Worst case scenario, we borrow it back from ourselves but stick to the original 25 year amortization. Best case scenario, the money is there if we need it but it’s not used and put to good use by getting us mortgage free in 12 years, not 25.

Ul @ Mi Bolsillo en el Norte
8 years ago

I would argue against handling the point of holding liquid investable assets as an emergency fund. Nowadays the yield of bonds and other fixed income instruments can, and actually is, lower than some HISAs. There are standard HISAs out there paying 1.8% at Ally and 2% in other places, and TFSAs like the one from Canadian Financial Direct paying 3%, all of these options with 0 risk.
Must of us should hold some fixed income vehicles, but likely they are better not being counted towards our emergency fund.

jay @ effumoney
8 years ago

I’m in my mid 30’s and have a six figure salary, my wife no longer works but receives insurance payments in lieu of her former salary, we have a net worth over $1 million, we had about $70k in cash across multiple accounts, we never had an official emergency fund, we just had cash assets. Early this year we had been faced with upcoming large uninsured medical expenses, we have since wiped out our $70k of cash. We knew this was coming so we refinanced our mortgage and backstopped ourselves with a HELOC. We have one more large payment due in the next 2 months, and then we can begin recouping our cash.

Everyone needs an emergency fund, we are well paid and have substantial assets and we needed our cash, we have not had to sell any assets or adjust our lifestyle since we had this cash. I am not saying if you have high interest credit card debt you need to stash a years’ worth of expenses, but anyone can get surprised with an emergency, we sure did.

Andrew Spencer
8 years ago

Using overdraft protection is about the same as using a credit card (~20% interest rate)…only main differences are it gets charged from the day the money is taken (no grace period) and there is usually also a service charge…

So…yeah, using overdraft as an emergency fund is pretty dumb

Melanie Samson - Cormier
8 years ago

I have a serious issues with the suggestion that overdraft protection is an acceptable alternative to an emergency fund for anyone. Taking on high interest debt is a bad idea at any time, let alone during a period of unemployment.

Sean Cooper, Freelance Writer and Blogger
8 years ago

Great points, everyone! Thanks for all the discussion. My main point is that everyone doesn’t necessarily need an emergency fund to cover a set time period i.e. 1 year’s living expenses. You need to look at your own personal circumstances and see the worst that could happen financially and plan for the financial shortfall, if any. That said, it’s always nice to have some sort of financial cushion in the bank, as you don’t want to end up living pay cheque to pay cheque since there are bound to be “unexpected” expenses that arise.

alex
8 years ago

Okay . . . but I’m still not at all convinced that for the folks you are describing it makes more sense to take money out of non-registered accounts rather than registered accounts. In fact, I’d argue the opposite is true.

The folks you are describing are exactly the ones who, in retirement, are likely to not see a big drop in income because of all of their investments. Consequently, they are likely to be paying the same or similar tax rate on their RRSP withdrawal as when they deposited it. In fact, to the extent that much of their RRSP contributions came early in their career, they are likely going to be taxed MORE on their withdrawal than the tax refund they received when they contributed because their tax bracket in retirement is actually higher than it was early in their career.

For these people, it makes even MORE sense to raid registered funds first, in instances of extended job losses because then they WILL pay less tax on the RRSP withdrawal (because their current tax bracket will be lower than the rate at which they contributed).

They still have the same amount of retirement savings whether they pull it out of Registered or Non-Registered accounts, right? The difference is that by pulling it out of non-registered accounts they get a tax break, whereas by pulling it out of non-registered accounts they don’t.

Yes, they will lose that RRSP contribution room. But so what? The big advantage of an RRSP is that it lets you defer taxes until, ideally, you are in a lower tax bracket at retirement. But for the folks you describe, this essentially never happens because they have been so good at investing and contributing that their tax bracket only marginally decreases at retirement if at all. For high income earners, RRSP tends to be only a tax deferral mechanism rather than a tax reducing vehicle. UNLESS, they can use it during times when their income really is lower — like periods of extended job losses . . .

Michael James
8 years ago

@Alex: I tend to come at this from the point of view of the type of most people I work with. Their pay is $100k+, and their families have developed a fairly expensive lifestyle. Although the typical Canadian can’t use all the RRSP room he has, the people I tend to work with bemoan the fact that they have no room left. For people like this, job loss means a long search for a new job and possibly a temporary job that pays only, say, $60k/year. For someone like this, raiding an RRSP should come after raiding non-registered savings. I can see why someone who can’t use all his RRSP room wouldn’t be worried about raiding an RRSP and permanently losing the room.

The media tends to be filled with a lot of nonsense. We should be striving for much more than a year’s worth of expenses in total savings. How much of this should be cash in a non-registered account is an entirely different question. I can’t imagine trying to run my finances without at a $10k cash buffer, buy YMMV.

alex
8 years ago

Sure, that’s all true. But there is no need to put your RRSP dollars exclusively into market funds.

Your ability to borrow evaporates quickly if you lose your job.

This is largely true only to the extent that they are looking to get access to new sources of credit. Which is why it is important to set up a good LOC when you have good credit rather than waiting until the wheels fall of the train. It is awfully rare for banks to remove your LOC later — despite myths to the contrary.

I’ve also observed that people who lose jobs tend to change their attitudes about reserve cash — they thought little about it before the job loss and think it’s more important afterward.

True. But I’d also argue that this is because they have been fed the line that RRSPs should never be touched until retirement. An RRSP is an extraordinarily useful tool whose value is extremely curtailed if it is thought of exclusively in terms of ‘retirement savings’. In times of extended job losses, it makes much more financial sense to take money out of an RRSP than it does to take money out of non-registered vehicles.

I am probably taking a more extreme position here than I actually believe, but only because the other position (i.e., ‘everyone needs a year’s expenses emergency fund’) is so dominant in the media. For most people, such a large emergency fund is not only unnecessary, but it prevents them from using that money for more productive purposes. Cash reserves probably have their place, but not at the expense of paying down debt and/or contributing to tax sheltered investment vehicles like RRSP and TFSA.

If you are worried about liquidity, then at the very least put your emergency fund in a registered money market account (assuming you have room).