An emergency fund is an account that is used to set aside funds to be used in an emergency, such as the loss of a job, an illness or a major expense. The purpose of the fund is to improve financial security by creating a safety net of funds that can be used to meet emergency expenses as well as reduce the need to use high interest debt, such as credit cards, as a last resort.
A general rule-of-thumb is that this fund should contain enough to cover three to six months expenses. These funds should be in a placed in a highly liquid, low risk vehicle - a cash or cash-equivalent account - such as a high-interest savings account (HISA) and can be held in a Tax-Free Savings Account (TFSA).
A poll of Canadians in March and April 2012 revealed 45 per cent of those surveyed had no fund set up to deal with emergency expenses.
Equities should not be used for emergency savings (or any targeted savings) because of the risk of an equity decline. The emergency fund provides security against having to sell longer term investments at inopportune times (e.g. selling equities during down markets). Some people consider a line of credit (LOC) to be an emergency fund. However, a LOC has to be paid back with interest, and also runs the risk of being withdrawn by the lender. A true emergency fund has no payback or interest obligation.
An emergency fund is aptly named because its purpose is to provide a source of cash when the unexpected happens. You should set up your savings based on the time required to obtain the funds.
Car problems and home repair are the typical uses for urgently needed cash. For these situations, it's best to have funds in a local bank, preferably with ATM access.
Needs within a few days to a few months
A high-interest savings account would be appropriate.
Needs longer than a few months
This timeframe is for unexpected events, such as the loss of a job. Using cashable Guaranteed Investment Certificates would be appropriate.
Exclusions & triage
Emergency funds should not be used to pay for discretionary purchases such as vacations or other major, planned expenses. The intent of the fund is to cover necessary expenses such as groceries, rent, or utilities.
In the event of a financial emergency such as job loss, spending discipline may require forgoing certain "normal" expenses such as dining out or entertainment. By avoiding spending on these types of items, emergency funds may be stretched to cover longer periods of time or additional emergencies before being replenished.
- Investopedia, Emergency fund definition, viewed June 15, 2012.
- The Globe and Mail, 45% of Canadians don’t set aside funds for emergency expenses, poll finds, viewed August 13, 2012.
- Financial Wisdom Forum topic: for a discussion of the pros/cons of using a HELOC as your emergency fund.
- Financial Wisdom Forum topic:
- Average Emergency Savings Fund up 18 per cent From 2014; One Quarter Living Paycheque to Paycheque: BMO Rainy Day Survey