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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.





23 Comments, Comment or Ping

  1. 1. alex

    Why exclude your Registered funds from this discussion?

    RRSP is not only useful for retirement. It can be a perfect venue for an emergency fund.

    Most people contribute to RRSP when they are making lots of money, so get a relatively large tax refund. The trick, of course, is that when you retire, you need to repay that tax refund — ideally at a rate less than you received by virtue of the fact that you earn less during retirement. Alas, for many great savers/investers, their tax bracket in retirement is not significantly lower than when they contributed to their RRSP, so it ends up being simply a tax deferral rather than a refund (still useful, just not as useful).

    If you lose your job, on the other hand, you are guaranteed to be in a lower tax bracket than when you contributed to your RRSP, so you literally DO get a tax refund rather than just a deferral when pulling out funds from your RRSP.

    Assuming you still have unused RRSP space, keeping emergency funds in a non-registered account doesn’t make a lot of sense. Better to keep it in a registered account and hope you never need to use it, but knowing that if you DO need to use it, you will at least get a tax break on your withdrawals.

  2. 2. FT

    @Alex, i’m not sure I agree with you there. Maybe in the case of a job loss, but what about the scenario where you need a new roof or furnace? Here’s an article I wrote about why an RRSP is not an emergency fund.

    http://www.milliondollarjourney.com/why-your-retirement-account-is-not-an-emergency-fund.htm

  3. Many of your ideas make sense when you think of an emergency fund for things like a new roof. However, the main purpose of an emergency fund is to keep you afloat when you lose your job and it takes time to find a new one. In this case lines of credit won’t work because banks will (quite sensibly) not lend you money. Any plan to use your “monthly cash surplus” won’t work either.

    It usually takes a job loss to make people respect the value of actual cash. Access to credit is no substitute. People differ on how much of a cash buffer they need, but most people underestimate their needs.

  4. Hi Sean,

    You made some excellent points but I like to add some meat here.

    Most group disability plans really cover you for two years. If you can do any type of work your benefits will be reduced by what you can earn else where.

    Here is some other points:
    Group disability insurance premiums are not guaranteed, and they can be adjusted by the insurance carrier on a yearly basis.

    Group disability policies can be cancelled at the discretion of the insurance company or the employer at any time.

    The employee does not control his/her disability plan. Instead, it is negotiated between the employer and the insurance company.

    Group disability insurance is not transferable to a new employer.

    Generally, the insured does not have the option to convert their group disability policy to an individual policy under a group disability policy if they leave and become self-employed.

    As far as Critical Illness insurance goes many companies do not offer it at all and the max coverage is maybe $25,000 to $50,000 with less illnesses covered.

    Many people are far better off buying their own coverage. Premiums can be set so they never go up and coverage can go to 65 or older.

    Brian

  5. 5. alex

    FT,

    But how many instances are there that are not already covered by insurance and that actually require anything near three months to one year’s worth of expense money? I honestly can’t think of many.

    Do roofs often catastrophically fail at unexpected times that would not be covered by home insurance? Or do they slowly deteriorate, during which time you should have saved up money to fix it. I’d argue roof failures are not an “emergency” in the sense that if you are saving money in an emergency fund by not fixing your roof until it catastrophically fails, you should not have been putting money into an emergency fund in the first place; you should have been fixing your darn roof.

    And I’d certainly argue that even a furnace (which can just up and quit) doesn’t require anything near three months to a year worth of savings.

    Can you provide me with any examples of when you would need an emergency fund worth one year of expenses in any instance besides job loss that is not already covered by insurance?

    Honestly, for most people, the only real emergency that is not covered by private insurance (but still is covered by EI) and that requires more than a couple of months worth of salary is job loss. Everything else doesn’t require a dedicated ‘emergency fund’ in a highly liquid account earning virtually no interest and not getting you a tax break.

  6. Great points Alex. Personally, I do not consider an emergency fund to be a “years” worth of expenses,but cash on hand in case the worst happens (or even buying opportunties). If someone loses a job and does not get severance, they will need funds to cover the gap between job loss and obtaining EI/new job. In this case, worse case is having funds to cover the gap. Even if they have disability insurance, and become disabled, they still need funds to cover the deductible period (3 – 6 months normally).

    Maybe it’s my overly conservative nature, but having some cash on hand prevents dipping into debt (or registered savings) when you need a bit of cash.

  7. 7. alex

    Meh.

    I think far too much emphasis is placed on emergency funds. Dedicating a year’s worth of expenses, as advocated by many financial planners, is ridiculous (for most people).

    Most people, most of the time, would be far better of paying down existing debt, paying off mortgages, contributing to RRSP and TFSA accounts, ensuring that they are properly insured, and that they have access to a LOC.

    Most people would lose more money by keeping a huge chunk of cash in a liquid account than they would earn by paying down debt (including mortgages) or investing that money.

    Just my perspective, obviously.

  8. I believe the emergency fund is really dependent on the nature of your work and where you are at in life. The more assets you have, the less you have a requirement to hold so much cash around. I usually like to approach the topic as a road map. In the event of a job loss, it’s important to know your ability to get back on your feet so you have the proper plan.

    When it comes to a home, every home owners should be aware of what needs to be done. A hot water tank isn’t suppose to last more than 10 years … some insurance companies charge you more when it’s older. I tend to agree with Alex on items related to a home. It should be planned as part of a maintenance/service cost over time.

    For the record, I don’t have an emergency fund. Finding employment is not an issue and I would get a severance package. I have also taken the proper steps to reduce debt drastically over the past 5 years due to many layoffs at my office. I have taken the steps to plan against a lower income for the family in the event I lose my position.

    On the flip side, I believe many people need an emergency fund. It’s important to understand all the points that you would use it for. Those that don’t plan, should have an emergency fund regardless of their situation :)

  9. I get acquaintances all the time aproaching me looking for a lead on a job. In most cases these people have been out of work for over a year, particularly the ones in their late 40s and 50s. When you get older and have fairly high expenses due to family, etc., the prospect of losing your job is scary. The important thing is to be able to withstand a long period without a pay cheque (or with a much smaller pay cheque). EI is mostly a joke for these people — payments are small and get clawed back. Access to credit is not a solution to this problem; you must have assets. These assets don’t necessarily have to be completely in cash, but it can be dangerous to have them entirely tied up in a home or stocks because these things are likely to have lower value at the time you’re forced to sell them.

  10. 10. Samantha

    I probably fit in the category of a renter (although hopefully not lifelong) with a stable high paying job, but I like to think of my emergency fund as an opportunity fund so that I can pursue whatever opportunities (job, investment, travel or otherwise) comes my way without having to worry about whether I can afford it. My goal is to save up one years pay.

  11. 11. alex

    These assets don’t necessarily have to be completely in cash, but it can be dangerous to have them entirely tied up in a home or stocks because these things are likely to have lower value at the time you’re forced to sell them.

    Can you provide any data to support the assertion that they are “likely to have lower value”? Are houses and stocks inherently likely to lose value over time? If so — why are you investing in them in the first place?

    In contrast, cashing in your RRSP during a prolonged period of unemployment IS going to give you a greater return on your investment than if you had cashed in non-registered funds, simply because your tax bracket will be lower than when you invested the funds. Plus, in the meantime, you have presumably earned greater interest by having the money invested instead of sitting in a low-interest liquid account.

    Again — the issue is not whether to save or not. Clearly we should all be putting money away for retirement/emergencies. The issue is where to keep those savings. I see no reason to keep an enormous liquid fund dedicated to ‘emergencies’ instead of investing that same money in registered plans (assuming you have not already maxed out your TFSA or RRSP).

  12. @Alex: Half the people I knew in high tech a little over a decade ago lost their jobs at the same time that tech shares lost more than half their value. Starting in 2008/2009, many Americans lost jobs at the same time that their homes lost much of their resale value. There is a positive correlation bewteen job loss and lowered value of some assets.

    Don’t think that I’m in the “have $100k in a savings account” crowd. I think it’s sensible to have some cash around, but each person’s needs are different. For example, I usually have about $25k spread across various registered and non-registered accounts. Before I had children, my ability to live frugally was much greater and I kept much smaller cash savings.

    I agree with you that some of the savings can be in different types of accounts. I also agree with you that people should be building assets. Where I disagree with some people is where they talk of using access to credit as an emergency fund. Your ability to borrow evaporates quickly if you lose your job. 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.

  13. @ Micheal James,

    I think you made some excellent points. Job loss means benefits are gone.

    Having one’s own policy (which can be added on to a company plan). Is one way of having a emergency fund if one becomes disabilied or sick.

    Three months of cash on hand while great will be burned through very quickly. Your health is more important than a job loss, assuming one can find work in a reasonable amount of time with the same benefits and pay the same pay.

  14. 14. alex

    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).

  15. @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.

  16. 16. alex

    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 . . .

  17. 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.

  18. 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.

  19. 19. Andrew Spencer

    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

  20. 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.

  21. 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.

  22. 22. Geoff

    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.

  23. 23. alex

    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/

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