Canadian Finance Blog

Personal Finance Basics: Build an Emergency Fund

Posted: 01 Feb 2012 02:00 AM PST

Last week we talked a little bit about some personal finance basics. First things are first, and you should start to spend less than you’re making. If your expenditures are greater than your income, it doesn’t matter how well you invest or how good of purchases you make, you’re still going to end up in a bad financial situation. So make sure that step one is to start your finances moving in the right direction. So what’s next? If you’re spending less than what you’re making, what should you do with the extra money? Should it just sit in your bank account, should you move it into investments, should you dump it immediately into debt? What’s the best thing to do?

What is an emergency fund?

At first, by far the best thing to do (other than making sure you’re not missing debt payments) is to build an emergency fund. What is an emergency fund? An emergency fund is simply a separate stash of money that is reserved exclusively for emergencies. Ideally, it is a separate bank account that is more difficult to access, so that you’re not tempted to use it – but accessible from anywhere, so that you can get it, in case of an emergency. Why not just use a credit card? When an emergency happens, and it will happen, it is obviously a lot better to simply have an interest free way of getting out of that situation. If you are forced to use a credit card, your emergency gets that much worse as now you have a deadline to get that money back, or else you’re paying interest on top of it. As a result, the best option for an emergency fund is an online bank account like ING Direct, or a separate bank account through your normal bank where you can stash the cash until you need it.

How big should your emergency fund be?

There’s plenty of advice out there about different formulas you can use to determine just how large your emergency fund should be. Dave Ramsey says it should be a thousand dollars, assuming you have debt to pay back. Get your emergency fund to 1k, then pay off debt, then make your emergency fund bigger. Others say the best thing to do is to figure out how 2 months worth of expenses, and save up that amount. That way, in case of emergency, you have 2 months to figure something out before you start going back into debt. In reality, it all just comes down to personal opinion. Do whatever makes you comfortable, but please save at least a minimum of a thousand dollars before you cut off saving for your emergency fund. You’ll thank me later.

How to save money in your emergency fund

What’s the best way of getting all that money into the emergency fund? Simple. Set up an automatic transfer (ING is really good with this, get a head start with an orange key) for the day that you normally get your paycheck. Set it for something easily manageable, like $30 or $50. Then, just wait. If you have a lump sum that you can set aside, then definitely put that in there straight away to get it going, but even with a modest regular deposit, you can grow your emergency fund in no time. Even at $50/paycheck, you can have your thousand dollar emergency fund in less than a year, and because you’re taking it out on the day that your paycheck goes into your account, you’ll never even notice the difference. Just make sure that you adjust your other spending accordingly so that you don’t start spending more than you make. Keep tracking your finances!

When should you use your emergency fund?

Finally, when should you use your emergency fund? Again, there’s plenty of rules and guidelines you can attempt to follow, but you simply should use your best judgment. If you think that buying a new TV is the best use of your hard earned money that you’ve been saving for an emergency, well then, go for it! Have fun! But when your car breaks down on the way home from the store, and suddenly you don’t have the cash for the mechanic to fix your only mode of transportation, well then, I guess you can’t blame me for not warning you. To best honest, my wife and I have dipped into our emergency fund for non-emergencies. When we purchased our car we drained it so that we could pay for the car outright, as opposed to getting a loan. We deemed it was worth the risk, even though it wasn’t an emergency. It worked out well in our favour, but we both were quite stressed about our finances until we built it back up again.

Do you have an emergency fund? Have you ever dipped into it? Why or why not?

Personal Finance Basics: Build an Emergency Fund originally appeared on Canadian Finance Blog on February 1, 2012.