Everything you need to know about emergency funds

You get a flat tire, a leak in the house, or you lose your job in the middle of a global pandemic. Life is full of bumps in the road and significant setbacks. They say that money doesn't buy happiness, but it sure does solve a lot of our problems. 

Without any spare cash to use in these emergencies, you may be forced to go into debt or make some very uncomfortable sacrifices. That's where the Emergency Fund comes in. 

But exactly how much should you save, and how should you use it? Here's everything you need to know.

Before starting an emergency fund

If you have outstanding credit card debt, it will continue to drag you down until you get rid of it. Some financial experts believe you should pay off your credit card debt entirely before starting an emergency fund. That's because credit cards (and some other consumer debts) carry exceptionally high interest rates in the range of 19-29%. While the average high-interest savings account only earns you 1-2%. Putting an extra $100 towards the debt instead of savings would be the mathematically right thing to do.

However, what you really want to avoid is having an unexpected emergency that puts you even further in debt because you had $0 in savings. This is why financial experts like Dave Ramsey recommend that you first have $1000 as a starter emergency fund, then focus on paying off that credit card debt as fast as possible.

Ultimately, it doesn't matter which of the two methods you choose. What's important is that you're starting to head in the right direction. So go with the one that feels right to you.

If your credit card debt has snowballed out of control, you can ask for help from several organizations and programs available to Canadians. Learn more about debt relief programs here. 

How much do you need to save?

This will depend on your situation. But think of your emergency fund as a replacement for your current salary. If you were to lose your income tomorrow, how much money will you need each month to get by?

If you're not already tracking your monthly spending, this is an excellent time to start. You can follow the simple spreadsheet method I explain in step 3 or use budgeting apps like Mint or YNAB

Figure out what the minimum amount your household needs to pay the bills, put food on the table, and cover any other necessities. Then multiply that amount by the number of months that makes sense to you. 

The sage advice used to be to have three months of living expenses in your emergency fund, but that was before coronavirus when unemployment rates were low. A three-month safety net just doesn't sound as big as it used to, especially if you have kids, a mortgage, or run your own business. Ideally, you should aim to have six months of living expenses in your emergency fund.

Where should you put your emergency fund?

Your emergency fund should be easily accessible and kept safe in a no-feeshigh-interest savings account.

It should not be mixed up with other saving goals or tied up in potentially volatile investments that you can't easily withdraw from (like your RRSP account). 

Here are some of the best options available to Canadians:

When should you use your emergency fund?

It's there to help you in a real emergency - like having to fly to visit a sick loved one or fix the boiler in your house. When you get back on track, focus on replenishing your emergency fund. 

Make a commitment to yourself that you won't dip into it to go on a last-minute vacation or to buy that thing you really want but haven't saved up for. 

Saving up an emergency fund is one of the most significant milestones of financial stability. It's not as exciting as buying Bitcoins or travelling to Italy, but it will buy you invaluable peace of mind.

Start the Emergency Fund Challenge for yourself by clicking Next Goal.