Planning & Advice

Do You Need A Rainy Day Fund?

February 23, 2016


Do You Need A Rainy Day Fund?

Planning & Advice

You’re out for dinner with friends and learn one of your best friends has been recently laid off. You feel for her. You hope she’ll be okay financially. She probably will be. You find out that Sally actually has a rainy day fund. She set it 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 and an investment portfolio. You read all the latest financial blogs. After some pondering, you think it might be a good idea for you to create a rainy day fund yourself. But do you actually need one?

Many financial institutions, books and blogs recommend setting up a rainy day fund. The typical advice is that it should be in liquid cash of 3 to 6 months’ salary. This will help you during times when your regular income is disrupted or major emergencies. Otherwise, a sudden job loss or unexpected home repair bill can hit hard.

The reality is it is hard for Canadians to save for a rainy day fund

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, but 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?

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The answer depends on your situation. There are many situations, but here are two very common ones:

Your (or your spouse’s) employment is seasonal, contract-based, or self-employed. 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. Saving is important to float you to your next source of income.

However, are things are more stable? Do you have a full time permanent position? Are you regularly investing? Got good credit? If you just don’t foresee any interruptions in your income, then a rainy day fund might not be your best option. If so, you will be better served by procuring an insured line of credit at a low interest rate.

Line of credit vs rainy day fund

Let’s start with what a line of credit is: A line of credit is an on-demand loan of money. You get it from the bank. You can draw upon it 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.

A line of credit is different from traditional loans. 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. The funds are available if you ever do need access to them, but you don’t pay any interest until you do that.  Over the long term, this interest rate is generally lower than the growth rate on your long-term investments.

Going with a line of credit frees you to invest the funds you would have normally saved into a cash savings emergency account, which pays very little interest. Alternatively, you could put it into a long term growth investment strategy that is in line with your financial goals and plan. But 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!

Some other things to think about before you start a rainy day fund

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. If you do have to withdraw money from your line of credit, you should have a plan in place to repay it as soon as you get back on your feet. But there is an opportunity cost of not having your emergency fund invested when you do not need it. You would be 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?

Finding yourself in a short term employment situation? Is it difficult to adhere to a saving plan? Are 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 you should have a realistic representation of the situation. 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,evaluate your expenses. See what you can cut (although doing this on a regular basis is good practice anyway). Check 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 may simply prefer having a cash fund account.

I’m still not sure of what to do…

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