September 2010

An emergency fund?
What for?

General wisdom has it that everyone should keep the equivalent of three months’ salary in reserve to cover unexpected expenses. It’s a great theory, but how do you put it into practice?

In Canada, only one person in 10 says that they have enough money put aside to cover an unexpected expense of just $500. In fact, even drawing on lines of credit and credit cards, 75% of Canadians would not be able to come up with $5,000 if they suddenly needed it.

This is revealed in a study made public recently by the Certified General Accountants Association of Canada. The study also shows that, despite the economic crisis, the majority of Canadians are not planning to change their savings habits in order to build the famous “emergency fund” that everyone is supposed to have.

Overconfident? You bet!

Emergencies on credit

These figures are very surprising:  they mean that when the need arises, Canadians expect to use credit rather than their own savings. This attitude is quite likely due to the fact that “emergency” seems to contain an element of unreality. Few things are more real, however, than a water heater that bursts, a home appliance that gives up the ghost, a transmission that breaks down, or a dental crown that needs to be replaced. That’s why financial planners generally recommend that their clients set aside the equivalent of three months’ salary to cover just such calamities... along with more serious misfortunes, such as job loss or illness.

How many months did you say?

The exact amount to have on hand for emergencies varies from person to person. Someone with a stable job in the public service and a comprehensive benefit plan might need to “cover” fewer months than a self-employed worker or a salesperson on commission. For these people, it is essential to be able to carry on until the situation finally improves or, in the case of disability, until the insurance kicks in. Similarly, a person who is responsible for supporting a large family should have a substantial emergency fund.

How to do it

To build an emergency fund, financial services professionals generally recommend using a combination of a high-interest savings account and a line of credit. The former can be used to cover the most urgent needs quickly without the cost of borrowing, while the latter can provide additional cash, if needed, at a reasonable rate of interest. For example, if you earn $40,000 a year and wish to establish a $10,000 emergency fund (three months’ salary), you could put $7,000 into savings and have an additional reserve of $3,000 in the form of a line of credit.

Since 2009, there has been an ideal tool for establishing a reserve fund:  the TFSA, or Tax-Free Savings Account, which allows you to save up to $5,000 a year in a sheltered environment where interest can accumulate on a tax-free basis. Withdrawals are also exempt from taxes. This means that, when you need it, you will have access to the full amount in your account, as opposed to withdrawing money from your RRSP, for instance, which would be subject to income tax.

And the credit card? Use it for other things, certainly. But at 19% interest, certainly not for an emergency fund. Otherwise, the emergency might turn into a chronic condition!