So you’ve paid off all your debt and want to start to build your savings and investments? Before you start working on building up your RRSP, your first savings priority should be an emergency fund.
I’ve mentioned previously that I don’t believe an emergency fund makes much sense if you still have debt. By paying down debt on a credit card or credit line, you then free up that balance, which could be re-borrowed in the event of an emergency.
At the same time, paying down your debt, especially if it is high interest debt, allows you to stop wasting money on interest payments. The longer you are in debt, the less money you have to build up your own wealth. One of the best things you can do for yourself is to get rid of high interest debt as soon as possible. Once that is done, it’s time to build an emergency fund.
Why an Emergency Fund Matters
If your debts are paid off, an emergency fund acts as a form of insurance. The money is there if you truly need it, without having to go into debt or withdraw from your RRSP.
Most often, emergency funds are described as a safety net in case of job loss. Another good use for an emergency fund would be to use it for your home or auto insurance deductible. Having the money saved in advance gives you the ability to raise your deductible to reduce your insurance premiums. This saves you money on premiums each month — money that you can put into your emergency fund to earn interest.
Building Your Emergency Fund
It’s likely that you’ll need to save up to reach your emergency fund goals, so how much is the minimum you should have in your emergency fund? Rules of thumb suggest that you save up anywhere between 3 and 12 months’ worth of expenses. I think a true bare minimum would be either enough money to cover one month’s expenses or your insurance deductible, whichever is highest. Maybe this is $1,000 for some, while it might be much more for others.
You might have to start small to reach your initial goal, and that’s ok. The important thing is to get in the habit of setting money aside. Put aside as much as you can until you hit your bare minimum. Use a high yield account so that you can make the most out of your interest yields.
From that point, keep adding savings from each pay cheque until you reach an amount you feel comfortable with. Once you have the total amount saved in your emergency fund, you can practically forget about it until the need arises.
You want to be able to get your money out quickly in the event of an emergency, so make sure that the money is in an accessible account. A high interest savings account, possibly within a TFSA, would be a good choice. However, it’s important not to have this money too accessible. A debit card linked to your emergency fund is usually not the best idea.
Keep in mind that this account is for true emergencies, not for a car, vacation or Boxing Day deal. Of course, now that you have an emergency fund, you can now start saving in separate accounts for these items as well!