You're out for dinner with friends and learn one of your best friends Sally has been recently laid off. You feel for her and hope she'll be okay financially, but you learn that Sally was savvy and secured herself with a rainy day fund she set up specifically for these types of situations.
You like to think you're financially savvy too; you've got a strategy with your financial advisor, an investment portfolio, read all the latest financial blogs and after some pondering, you think it might be a good idea for you to create a rainy day fund yourself. But the question is, do you actually need one?
Many financial institutions, books, and blogs recommend setting up a rainy day fund in liquid cash of 3 to 6 months salary to help you during times when your regular income is disrupted or major emergencies. Situations such as sudden job loss or unexpected home repairs can hit hard if you're unprepared.
But that's a lot of change to have sitting in an account. For many Canadians, saving to your RRSP & TFSA is already hard enough, now you also need a cash savings account? While it's possible, for most it's not realistic. Not only that, most these accounts lose value over time being able to only sit in a high-interest cash savings account at best. So is it really something worth doing?
The answer depends on your situation. There are many situations, but here are two very common ones:
If your (or your spouse's) employment is seasonal, contract-based, or self-employed, then having a safety net like a rainy day fund probably makes a lot of sense. If you have an emergency, you don't want to resort to high-interest debt avenues such as credit cards to aid you during these times - so saving is important to float you to your next source of income.
However, if things are more stable and you have a full-time permanent position, you're regularly investing/saving, have good credit, and don't foresee any interruptions in your income then a rainy day fund might not be your best option. You will be better served by procuring an insured line of credit at a low-interest rate.
Before we explain the benefits let's start with what a line of credit is: A line of credit is an on-demand loan of money extended to you by the bank that you can draw upon when needed at a low-interest rate. Often these can be insured in case of critical illness or other emergencies. Think of it as a pre-approval for a loan that you don't need to use.
Further, a line of credit differs from traditional loans by having you pay interest only when it is being used. For example, let's say you are approved for a $30,000 line of credit and you don't use it; well then you won't pay any interest on it but the funds are available if you ever do need access to them.
Going with a line of credit is beneficial because it frees you to invest the funds you would have normally saved into a cash savings emergency account (at 0.0%-0.8% growth annually), into a long term growth investment strategy that is in line with your financial goals and plan (that can grow at 5%-10% annually on average). Keeping it in cash means your money loses buying power over time. The same dollar today won't buy as much tomorrow. Investing it means you grow. The difference can mean hundreds of thousands of dollars gained over a lifetime!
So, when you find yourself in a situation where you need to draw funds, your line of credit allows you to access this cash at a low-interest rate. Over the long term, this interest rate is generally lower than the growth rate on your long-term investments.
Some things to consider: Usually, though not always, people tend to lose their jobs or have less job stability in tumultuous economic environments. This is usually the time of low-interest rates and low rates of return. Pulling money out of your long term investments is probably not something you may want to do, however tying your insured line of credit with the prime rate will ensure that your interest rate on your loan will be low.
We are not advocating that people incur debt. You should ensure that if you do have to withdraw money from your line of credit that you have a plan in place to repay it as soon as you get back on your feet. What is important to consider is the opportunity cost of not having your emergency fund invested when you do not need it and losing purchasing power by having it sit in low-interest cash account. This may be a bigger loss than the interest you may pay on those borrow funds.
Sounds good. I think I should still start a rainy day fund. How do I do that?
If you find yourself in a short term employment situation, find it difficult to adhere to a saving plan, or things are a bit unpredictable, then a rainy day fund might be good for you. So what do you need to do to start a rainy day fund?
First: determine how much money to put aside. This amount is dependent on your circumstances. You might have a bunch of important expenses that aren't optional such as a mortgage or kids (lets make sure they can eat...). A simple rule of thumb is to have 3-6 months of income saved but this is slightly shortsighted since many people spend more than they make.
To go more in depth, look at how much you have spent on average each month over the year, and account for 3-6 months of expenses instead.
Now that you have a realistic representation of the situation you are in you can determine how much money you can start putting aside monthly or bi-monthly. Set up automatic contributions to a high-interest savings account or to a TFSA to develop your rainy day fund.
When the day comes that you may need to access it, you should evaluate your expenses, see what you can cut (although doing this on a regular basis is good practice anyway) and see if you have access to alternative income sources from social programs such as employment insurance (E.I).
Now that you know all this, what should you do?
The benefits of going with a line of credit or a rainy day fund is entirely dependent on the situation you find yourself in and what you are comfortable with. You may simply prefer having a cash fund account. Either way, a financial dilemma is certain to occur and how you are affected is best determined by how well prepared you are.
Tea Nicola is the Co-Founder and Chief Executive Officer of WealthBar, Canada's only full-service online financial advisor offering diversified portfolios of low-cost ETFs, insurance and financial advice. Passionate about personal finance, Tea is looking to change the way Canadians save by making investing smarter, more transparent, and at more than half the cost of traditional advisors.
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