An initial emergency fund is a reserve of money designed to get you through unexpected payments without having to go into debt. Some people call it a “rainy day fund.” Read ahead to find out why you need to create this fund, when to use it, how to get it started and more.
Why Should You Start an Initial Emergency Fund?
An emergency fund is like a form of insurance. At first, it seems strange to put part of a paycheque into an untouched account instead of incorporating that money into your regular budget. But, you will be thankful that you have left the funds untouched when an emergency expense crops up. You won’t appreciate the financial resource until you really need it.
Having an emergency fund allows you to quickly pay an unexpected cost without causing yourself trouble in the future. It’s a safety net that protects you from doing something financially risky in order to solve an immediate problem.
Without an emergency fund, you have to dip into your budget to settle an unexpected payment. It’s possible to do this if you have a roomy budget, where hundreds of dollars are left over after dealing with essentials like housing, utilities and transportation. In that case, the emergency costs might not have much of an impact on your financial security whatsoever.
But, most people don’t have hundreds of untouched dollars sitting in their budget. In fact, a survey from the Canadian Payroll Association in 2017 found that 49% of Ontarians are living from paycheque to paycheque. They can’t sacrifice anything from their budget in order to get by.
So, what does someone do if they can’t stretch their budget? Put it on credit.
In an emergency, you will be tempted to put the expense on your credit card or line of credit. Once you put that emergency expense on credit, it can be difficult to pay it off right away. You will likely have to pay off the credit incrementally, while it builds interest and pushes you deeper into debt. It will be harder to pare down that number if you’re living from paycheque to paycheque.
The emergency fund also prevents you from turning to funding like a payday loan to access money in a hurry. These also go by names like cash advance loans or cheque advance loans. These have notoriously high interest rates and fees that build up rapidly. They are tempting because they let you gain access to funds in a short amount of time and they don’t have many restrictions for applicants. Almost anyone can get a payday loan.
Turning to payday lenders can have terrible financial consequences. They are a common reason for insolvency. The decision can plunge you deep into debt and have you paying off one small loan for years. The CBC program The Current conducted a segment about a man who took nine years to pay off a $200 payday loan — the interest over the years was over $31,000. He could only pay it off with the help of a generous donor.
The emergency fund is a low-risk solution that lets you deal with an expense in the present without hurting your finances in the future. It’s the best way to guarantee that you can make it through a problem without ruining your budget and going into debt.
Here are some other reasons for having an emergency fund:
How Much Should You Have in the Fund?
In this case, an initial emergency fund is designed for small one-time inconveniences — it’s not a nest egg to use for significant life changes. The latter is a long-term emergency fund, which is designed to give you financial stability when a source of income is taken away or a rush of large payments come in. It requires 3 to 6 months’ worth of living expenses. It’s for scenarios like losing a job, getting very sick or dealing with bereavement.
A long-term emergency fund is not an ideal goal for people living from paycheque to paycheque or who have significant consumer debt. Ideally, you want to plan for the smaller obstacles first.
In an initial emergency fund, you should have between $500 to $1500 stashed away. You should keep it in a separate savings account.
Storing these funds in your main savings or chequing accounts is not a wise decision. For one, you will be forcing yourself to calculate every purchase you make so that you that the emergency stash isn’t ruined. Secondly, the temptation to use the extra funds will be stronger when it’s already sitting in an account that you use for everyday expenses. It’s better to keep the money out of sight and out of mind.
The same problem happens when you have the funds in cash. It’s true that the cash can be accessed quickly, but its accessibility makes it more tempting to spend. If you like the idea of having cash, you should consider only taking out a small portion of the fund in bills and storing it in a safe place in your home. That way, the entire fund isn’t depleted if you decide to spend the cash in a situation that isn’t an emergency.
What Constitutes an Emergency Expense?
An emergency expense is a one-time expense that is both essential and urgent. You cannot afford to ignore this problem and you can’t put off the payment to a later date.
A good example of an emergency expense is when your car breaks down during your morning commute and you need to take it in for repairs. If you don’t solve this problem, you won’t be able to use your car for transportation. For many drivers, this means not being able to get to work, go grocery shopping, pick up their children from school or get to important appointments. It could make your life difficult and force you to spend more money on alternative transportation (e.g., public transit, taxis, rideshares) before paying for car repairs.
Since you require the car for transportation and accessibility, the payment is essential. And since you need the car to be repaired as soon as possible, the payment is also urgent. With those two qualities, you can see that it’s easily deemed an emergency expense.
However, not all inconvenient expenses are emergencies. If you stick with the car scenario, denting your passenger door or scratching the bumper are not emergencies. Your car can still run safely with these minor forms of cosmetic damage. You can fix them in the future or save your money and live with a messier car.
If you’re still unsure about what constitutes an emergency, read these common situations that you might encounter:
Examples of car emergencies:
- Faulty brakes
- Flat tire
- Broken windshield
- Furnace failure
- Frozen pipes
- Broken refrigerator
- Fallen tree branch
- Urgent dental problems (broken tooth, infection)
- Urgent veterinary appointments
- An unexpected bill or payment deadline
Examples of home maintenance emergencies:
Other examples of emergency expenses:
How Do You Make an Emergency Fund?
If you don’t have enough money to pour into an emergency fund straight away, don’t worry. There are plenty of methods that you can use to trim monthly costs, collect money and pool it all into one savings account. It’s possible to set a minimum of $500 aside for a rainy day.
The first thing that you need to do is modify your budget to meet your savings goals. Take a good hard look at your expense and income worksheets. Ignore essentials that can’t be trimmed like rent/mortgage. You won’t be able to haggle the price for these crucial payments down.
Take a look at essentials that could be trimmed. Utility bills can be brought down with energy-saving habits like turning down the heat during the day or unplugging electronics when they’re not in use. Grocery costs can be lowered by taking advantage of discounts, coupons and sale codes.
Then, look at the discretionary expenses — these are also called non-essentials. You don’t need these to survive, but you certainly appreciate having them in your life. These are payments for gym memberships, clothing, takeout food, restaurants and entertainment. These areas can be smaller. For instance, you could save lots of money by working out at home. You could avoid takeout food and restaurant prices by cooking from scratch. Instead of going out to the theatre for a date night, you can make popcorn and stream movies or television shows in your living room.
If you’re having trouble creating a comprehensive budget, you should click here to read about budgeting basics and follow the step-by-step guide on how to do it. You can easily come up with a plan that works for you and helps you meet your goal of making an emergency fund.
You can also find ways to elevate your income. By increasing how much money you bring in every month, you can reach your emergency fund much faster. Or, you can make sure that you sacrifice less from your regular budget. That way, you can comfortably afford your gym membership or that date night to the movie theatre.
Here are some ways that you can increase your income:
What If You’re in Debt?
Making an emergency fund is very practical, but it doesn’t make much sense when you’re deeply in debt. When you’re given a choice to pay debt or save money for a future safety net, you’re going to take care of the debt first. Your debt can grow. Ignoring it is not a feasible option.
When you’re trying to get out of debt, but you’re struggling to make a dent in the numbers, you should come to licensed debt professionals like David Sklar & Associates to sign up for financial counselling services. You will appreciate lessons like how to pay off credit, how to rebuild a poor credit rating and how to deal with collection agencies.
When people struggle with personal issues that contribute to financial instability, we can lead them to the best support agencies. Issues like compulsive shopping and gambling addiction can’t be dealt with through budgeting strategies and credit counselling alone. The root of the spending problems must be addressed before financial relief can be achieved.
After you’re finished reducing debt for financial security and you’ve reached a comfortable level of stability, you can turn back to your goal of making an emergency fund. The minute that you’ve hit your debt management goal, you have to jump to the next best thing. By building up an emergency fund, you can make sure that you don’t fall back into that debt problem all over again.
What Happens When You Use It?
Your car has a flat tire. Your bathroom toilet isn’t working. Your molar needs to get pulled. When you finally encounter a small expense that is essential and urgent, you can allow yourself to dip into the reserve and make the payment as soon as possible.
As soon as the problem is solved, you need to refill that emergency fund. Draining the account and leaving it empty will make you vulnerable. You never know when another expense is going to crop up. Put in the effort to replenish the amount so that you have the same financial relief in the future.
When you no longer have unsecured debt, you can work towards a long-term emergency fund. You will need to calculate three to six months’ worth of expenses — this includes everything from rent/mortgage payments, car payments, utility bills and groceries. After you find the exact number, work your way to collecting that amount in a savings account. You can eventually reach that goal, slowly but surely.
An emergency fund won’t feel important until you need it. A small stash of savings can help you deal with an unexpected problem right away. You don’t have to panic when you need an urgent trip to the dentist or when your kitchen sink gets clogged. You can get to your funds and let out a sigh of relief.