A guiding principle of personal finance is to hope for the best, but prepare for the worst.
Accordingly, I'm labelling 2016 as the year of the emergency fund. If you don't have some readily accessible cash to help you cover a surprise expense or job interruption, start saving.
The best outcome for the year ahead would be a sustained rise in oil prices and a stronger overall economy that increases demand for workers and firms up job security for people already employed. The worst is that oil prices keep falling and the economy continues to struggle in a way that threatens the security of the income your household depends on.
This is where the emergency fund comes in. It's how you survive a financial setback without raiding your retirement savings, adding to your line of credit debt or borrowing from relatives. Think of an emergency fund as insurance against a short-term setback that affects your long-term financial goals.
Hectoring people to have an emergency fund is something personal finance writers do from time to time, even though it probably ranks 357th on the list of topics people ask about. The reason is that there's such a big payoff from having money in reserve. Less stress, less damage to your finances.
Now seems an opportune time to return to the emergency fund theme. The Bank of Canada indicated last week that it would consider using negative interest rates, an extraordinary measure already in use in some European countries, if the economy worsens significantly. Governor Stephen Poloz believes the makings of a recovery are in place, and he doesn't expect to have to resort to negative rates. And yet, oil prices last week hit their lowest point in six years.
I took a look at our household emergency fund recently and decided we needed to up our game. How about you?
Definition of an emergency fund: Money sitting in a high-interest savings account at a bank or credit union. These accounts are insulated from the ups and downs of the stock and bond markets, and easily accessible online. Interest rates are pitiful on these accounts, but the emphasis is on safety over returns.
The weakness of our personal financial safety nets can be seen in some data presented in a recent report from the C.D. Howe Institute. It says that one in five mortgage holders had less than $5,000 in financial assets to cover an income disruption or interest rate increase in 2012, and close to one in 10 had less than $1,500 to cover emergencies.
Ideally, you'd have an emergency fund big enough to cover several months' worth of expenses. Smaller amounts are well worthwhile, too. Having enough to cover mortgage payments or your rent for a month or two is a great start.
You can build an emergency fund by making regular contributions to a savings account; a faster way is to use a lump-sum amount like a tax refund, bonus or gift. Another approach is to re-route some money you have put away for another purpose. Maybe you take a lesser vacation in 2016 and put half your trip savings into an emergency fund.
Keep your emergency fund in a tax-free savings account so that income taxes don't erode your already small returns. Note: Some online and alternative banks offer somewhat higher rates on TFSA accounts, even if only through temporary promotions. My emergency fund is held in a TFSA at Peoples Trust and the rate as of last week was 2 per cent.
Your retirement savings are not an emergency fund. Neither are lines of credit, although some people think they are because they're so easy to access and the interest costs are so low in comparison to loans and credit cards. Each dollar you borrow on your credit line will have to be paid back when your financial emergency is over. That's money that might otherwise be going toward retirement or your children's university education.
Emergency funds are most important for younger householders with mortgages and so many other financial commitments. But retirees have to consider emergency expenses. Living in a home or condo means there's a risk of major repair costs or special assessments, and health care emergencies are another possibility.
The more pressing reason to have an emergency fund right now is the economy. Hope for the best in 2016, but prepare for the worst.
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