Over the weekend I was pleased to see an article on Emergency Funds by Rob Carrick from the Globe and Mail – see his article here. We have been talking a lot about Emergency Funds recently and specifically how to better convince people of their importance. In our experience, not a lot of families or individuals have an emergency fund nor are particularly interested in the subject. If they have the funds set aside it’s usually because they have it earmarked for something specific or just haven’t got around to investing it yet.
I found it particularly interesting to read some of the online comments in response to Rob’s article. Some asked how you can recommend savers try to accumulate an emergency fund of a few months of living expenses when that might be all they have invested, especially when interest rates are so low. While yes, rates on GICs are low, we agree with Rob that it should still be a priority. Let’s start with the situation for those who don’t have any savings whatsoever – it’s definitely worth foregoing next year’s vacation or other planned discretionary spending items to start an emergency fund (sorry, this is a tough one for the holiday season). If you have nothing at all in reserve and something comes up like a job loss or urgent unexpected spending need, the options available if you have no savings can be very costly. For some that means credit cards, for others loans or lines of credit with higher interest rates, both things that are better left avoided.
Even if you have plenty of surplus cash, an emergency fund is still a good idea. An urgent and unexpected need for funds might coincide with a terrible time to sell your other investments (for example a lot of people tend to need their emergency funds at tough economic times which can coincide with market lows) or might trigger an unwanted tax event. There are also psychological benefits to having an emergency fund set aside. It will give you confidence to know that when an emergency happens you have provided for it and despite the current tough situation, you can take comfort that as a result of being prepared you don’t have to dip into your long term savings. In our experience this makes people feel just as good or better than trying to get as high a return as possible on their overall portfolio.
In the same way people don’t like to think about life or disability insurance because it raises unpleasant subject matter, so to does the emergency fund. The need for it likely means something bad is happening so some prefer to ignore the unpleasant subject all together.
For the emergency fund we usually recommend three to six months of living expenses – erring towards the high end to the extent your expenses are less discretionary (think mortgage or other loan repayments), your employment income is less certain and your financial situation is less liquid.
The Globe and Mail website also has a handy reference page for finding which GICs are currently on offer ranked high to low by the one year interest rate offered. You can usually find it at the bottom right of the Personal Finance page – click here for the link.
In terms of what type of account to hold your emergency fund in, we’d agree with Rob Carrick to put it in a TFSA but only if you don’t have enough funds to max out your contribution room with funds for long term investment purposes. The TFSA is a very powerful account for compounding tax-free investment returns over the long run and we recommend prioritizing contribution room in a TFSA for long term investment purposes if you have the funds. The tax you’ll save on a GIC by holding it in a TFSA is minimal compared to the tax you’ll save from other higher return assets you might hold in your TFSA. In fact it’s a shame the TFSA is called a “Savings” account in the first place. Perhaps Tax Free “Investment” Account would better alert investors to its benefits – for more on harnessing the power of the TFSA account see this piece from April.
So again, we don’t like to think about the situations that might necessitate the use of an emergency fund and as a result many choose to ignore it in the same way they might ignore sensible life insurance, however it’s there to protect our families when we need it so is more than worthwhile.