Part 2 of the series “The Basics”
Most financial planning blogs and books will emphasize the importance of having an emergency fund. This post will help you assess (1) why do you need one; (2) how much do you need; and (3) where should you keep the money.
(1) Why do you need one
An emergency fund is meant to ensure that your core fixed costs are paid for in the event of a financial emergency (job loss, illness, etc). This means that the emergency fund would cover the cost of:
- Health care
- Personal expenses
An emergency fund is not meant to replace your dependence on God.
And my God will supply every need of yours according to his riches in glory in Christ Jesus.Philippians 4:19 (ESV)
That said, planning for emergencies and having adequate insurance as a means of providing for future needs is a biblical principle.
A prudent man foresees the evil, and hides himself; but the simple pass on, and are punished.Proverbs 27:12 (ESV)
But if anyone does not provide for his relatives, and especially for members of his household, he has denied the faith and is worse than an unbeliever.1 Timothy 5:6 (ESV)
(2) How much do you need
General recommendations is that emergency funds should cover 3 to 6 months worth of expenses. So which one should it be? The answer to that question is very situation dependent, and generally depends on how risky your lifestyle is. Here are some general guidelines:
- 3 months would be appropriate if you have steady job with either an established company or the government, or have more than one household income.
- 6 months would be appropriate if you have a job that is prone to rounds of layoffs, are self-employed, don’t have short term disability insurance, or work at a start-up that carries a higher degree of bankruptcy.
This is not a binary decision, you may decide that a 4 or 5 month emergency fund is appropriate for you based on the factors and variables outlined above.
(3) Where should you keep the money
The savings should not be invested in risky assets. If they are they should be in very low risk investments such as GICs, short-term bonds, or cash. Generally speaking the lower risk the investment, and the more accessible the money is, the better. It is sometimes helpful to think of the emergency fund as an insurance policy against financial shock rather than an asset that you can expect to get an expected rate of return on.
There are a couple of places that you can keep your emergency fund:
- A high interest Tax Free Savings Account (TFSA) with a CDIC insured institution. This makes the most sense if you have unused contribution room because all interest earned will never be taxed.
- A high interest savings account with a CDIC (1) insured institution. This makes the most sense if you don’t have unused contribution room in your TFSA. All interest earned in this account will be included in your taxable income.
Having an Emergency Fund is not meant to be a substitute for relying on God for his provision. However, having an adequate Emergency Fund is a critical part of any financial plan, as they help you absorb financial shocks without having to worry about going into debt.
(1) CDIC is the Canadian Deposit Insurance Corporation, a federal Crown corporation that protects your deposits for up to $100,000 at CDIC member financial institutions.