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Debt prevention: The elusive emergency fund

'Emergency' photo (c) 2012, Tax Credits - license: you have an emergency fund?  According to an article published in the Globe and Mail in early September, 54% of Canadians have more than three months of savings available.  Are you among them?

We’ve been talking a lot lately about preventing and getting out of debt.  Last week, we discussed how to prevent debt by saving for annual expenses.    Another important way to prevent debt is to have an emergency fund.  By having adequate funds readily available for emergencies, the need to pull out the credit card is greatly reduced.


How much is enough?

There is no exact answer to this question because it is impossible to predict the circumstances that could happen.  Generally speaking, most financial planners recommend between 3 and 6 months of expenses, but there are some who recommend more.  It really depends on your situation.

The most common emergency that people face is job loss, so a starting point for discussion could be:  “If you or your spouse lost their job tomorrow, what would you do?”   How difficult would it be to find an equivalent position?  A higher income position is going to be higher to find an equivalent for than a lower income position simply because there are fewer options.

Do you have a dual income household?  Are you spending both those incomes already?  If yes, then you may need a higher emergency fund than a single-income household.  A stay-at-home husband might be able to get a temporary position (even if it is low paying) to help supplement the family income without affecting his previously-employed wife’s Employment Insurance benefits while she is looking for a new job.  If both spouses had previously been employed full-time, their capacity to generate new income is limited.

Do you have other potential disasters to consider?  In our house, it’s possible repairs.  We live in the country.  Our septic system and our furnace are original to our house, which was built in 1989.  We hope that both will last forever, but we need to be prepared for the need to replace them quickly if necessary.  If my house is freezing and/or we can’t flush our toilets, I don’t want to have to worry about financing our dilemma.  Dealing with contractors in our icy “outhouse” would be stressful enough.  I want the money available right away.  Perhaps you don’t have a septic system or an old furnace.  Maybe for you, it’s a car that’s on its last wheels, windows that are starting to leak, or some other annoyance.  These types of repairs and replacements should be factored into your emergency fund.

Employment Insurance benefits

In Canada, Employment Insurance benefits are available if you are eligible.  The amount that you receive depends on many factors, but as of January 1, 2012, the basic calculation is 55% of your average weekly insurable earnings, to an absolute maximum of $485 per week.  EI benefits are taxable, so the net amount that goes to your bank account is even less.  There is a two week waiting period where no benefits are paid and it can take even longer than that for the first payment to arrive.  Benefits are payable for 14 to 45 weeks depending on the unemployment rate in the region where you live and the number of hours of insurable employment that you accumulated during the qualifying period.  Could your family meet its financial obligations on EI benefits alone?  Probably not.  An emergency fund to cover expenses beyond EI is necessary.

I’ve got debt – should I start an emergency fund?

If you ask 3 money experts this question, you’ll probably get 3 different answers.  In most circumstances, I would say not to start an emergency fund until your credit card debt is paid off.  However, I would start to save for annual expenses (as explained last week) before your credit card debt is paid off.  The reason to save for yearly expenses that you know are coming up is that you’re breaking the habit of using your credit card.  You know that those expenses are going to happen and you’ll be using the money within the year.

By contrast, emergency funds are for extraordinary circumstances and non-recurring expenses.  If you have to use a credit card or credit line during a true emergency, I do not believe that is habit forming.  It’s also hard for me to stomach seeing thousands of dollars sitting in a 1% interest-generating account for years when 18% is being paid out in credit card interest.  I would much rather see the emergency fund contributions go to getting rid of the credit card debt first.

That being said, if your credit rating is so terrible that there is the danger that your bank is going to shut down your credit channels, you may be justified in building up a small emergency fund first.  If that’s the case for you, I would strongly recommend sitting down with a debt counselor and deciding a personalized plan of attack for your finances.

Where should I put my emergency fund money?

In Canada, the clear winner for this is a tax-free savings account (TFSA). I explained how those work in last week’s post.  Within your TFSA, you should choose a guaranteed investment that is not going to fluctuate in value.

Do you have an emergency fund?  How many months’ worth of expenses did you use as your starting point?  Are there other factors that you considered that I haven’t mentioned here?  Please let me know in the comments.


October 1, 2012

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