The Value of Emergency and Sinking Funds
On February 13, 2023, Statistics Canada released a report that found one in four Canadians was unable to cover an unexpected expense of $500. The report went on to compare age groups, racialized groups, and regions. If you are 35 to 44 years old, Black or South Asian, and you live in the Atlantic or Prairie regions, you are likely the least prepared for a financial emergency.
In this blog post, I suggest a couple of ways of preparing in advance for these kinds of costs.
An Emergency Fund: What’s the Point?
I have heard some argue that there is no value in setting up an emergency fund. If you have adequate earnings, you will do better to set up a line of credit and use that emergency money for long-term investing. For those at the lower end of the income scale, savings are impossible anyway, so what’s the point of even trying?
Not everyone is going to be convinced, but I would point out that even businesses will build cash reserves into their financial structure. Many corporations build into their financing a certain amount of borrowing, the issuing of bonds being one example, but they also maintain a cash reserve for unanticipated expenses.
It might seem an impossible task for those with lower incomes to set aside cash savings, but there are methods you can take. Even those with higher incomes may have a hard time setting aside savings in an emergency fund if they are used to spending every dollar they make.
An Emergency Fund: What’s the Path?
Regardless of your income level, the steps to take to begin saving money are more or less the same.
Track Your Expenses
Some might say that you should create a budget. That’s a good idea but given the often allergic reaction to even the word “budget” let me propose that you track your expenses. There are all kinds of apps out there that you can put on your phone that will help you out if you want. Your bank or credit union may have a similar tool. At the other extreme, you can simply go “old school” and get a folder where you toss in all your receipts. At the same time each weekend, you set aside some time to tally up your expenses and put them in broad categories like shelter, clothing, food, etc. You can further subdivide these categories. For example, food can include sub-categories for groceries and restaurants/take-out/delivery.
Start Where You Are
Once you have a good picture of your expenses, you will begin to recognize costs that are unavoidable, so-called fixed costs, like your rent or mortgage, and utilities, and those that are more flexible, like entertainment expenses. Many claim to have “cut the cable,” referring to cable television services, but they may have more than replaced the cost with services like Amazon Prime Video, Apple TV, Crave, or Disney+. Marie Kondo was all the rage a few years ago with her de-cluttering method; I haven’t heard much about her recently, but her idea of assessing the value of something in terms of its ability to “spark joy” can certainly be applied to your spending that is more flexible or discretionary. I think that a lot of time we leave our spending on default, subscribing to services that we don’t use that often. Does that largely unused service add to our well-being or would we do better to know that we have a bit more money set aside for when something breaks and needs replacing?
Access Government Benefits
Householders with low incomes often feel it may not be worth their while to file their income tax returns because they don’t think they will owe anything or get anything back. However, some benefits should be considered that can put money in your pocket.
Canada Child Benefit
If you have minor children in your household, especially if they are under age 7, you may qualify for the Canada Child Benefit (CCB), a tax-free infusion of money. Two things to attend to here. First, you need to file a tax return. Second, because the government determines the amount of your benefit by using net income, it can be of value to contribute to your RRSPs, as RRSP contributions reduce your net income. While TFSAs are often preferred if your income is below roughly $50,000, if you have children, contributing to an RRSP can make a meaningful difference to how much of the CCB you will receive.
Medical Expense Tax Credit
Another reason to file tax returns is to claim medical expenses. If married or in a common-law relationship, the lower-income spouse/partner should apply for this credit. Examples of some other deductions and credits can be found here.
The point in using these benefits, credits, or deductions is that more cash is returned to you, allowing you a bit more room to build up your emergency reserves.
Chipping away here and there may seem like a slow path to take. Most of us would probably like a winning lottery ticket instead. But the odds are against any one of us succeeding that way. You would probably do better to save that 5 dollars and put it into your emergency fund.
An Emergency Fund: How Much is Enough?
The general guidance is that you should set aside between three and six months’ worth of your household expenses after income tax. If you are part of a household that spends $72,000 per year, that means a minimum of $18,000 and up to $36,000. I might even encourage you to save more. That may seem like an intimidating amount if your household finances have been characterized by the proverbial “living paycheque to paycheque.” If that’s how you are experiencing this suggestion, then I suggest aiming for $500 to start. Don’t become a member of that Statistics Canada cohort.
A Sinking Feeling? No, a Sinking Fund
We may often have a sinking feeling about our funds, but what is a sinking fund? This is a pot of money that is built up over time and segregated to be spent for a specific purpose in the future. For example, let’s suppose you want to spend $6,000 on a vacation to a sunny destination next winter. One option is to put everything on a credit card or a line of credit when next winter rolls around. You are then challenged to pay down that debt that is compounding every month, hoping to get it down to zero before you have the following year’s vacation scheduled. The approach with the sinking fund is to set aside $500 each month beginning now with the express purpose of spending it on your vacation. Depending on the interest rate you are getting on your savings, you should have also accumulated a little bit of interest that can be carried into next year.
Another example might be a car. Transportation is one of the costliest household expenses. Depending on where you live, there may not be a public transit option, so an automobile is a necessity. Whether you buy new or used, it’s not unusual to spend a minimum of $25,000 and if you opt for a fully equipped pickup truck you could be spending close to $100,000. Let’s suppose you want to buy an SUV for $40,000 and you have to pay 7.2% annual interest, compounded monthly, over 6 years (72 months). That works out to about $686 per month or a total of over $49,000 over those 6 years.
Readers of this blog post who are interested in getting debt under control would do well to listen to the podcast – or watch the YouTube version – Debt Free in 30, Hosted by Licensed Insolvency Trustee (LIT) Doug Hoyes. The reason I bring Debt Free in 30 to your attention now is that I have heard more than once on his show how car loans have created trouble for people who subsequently became clients of the firm Hoyes operates with fellow LIT Ted Michalos. There are car loans available for 84-month (7-year) terms, which sometimes leads people to trade in their current vehicle for a new one before the old one is paid off, rolling the old debt into the new loan. This can lead to a situation when the amount of the car loan is greater than the value of the car they are buying. Do that for a few cycles and it becomes increasingly difficult to ever get out of debt.
Here’s where a sinking fund for auto purchases can work for you. These days it is reasonable to expect a car to function reasonably well for 10 years or more. If you buy a new car every 10 years, you have 120 months of savings that can go into a fund to pay for the vehicle outright when the time comes. For a $40,000 purchase in 10 years, $287 per month saved at 3% interest will get you where you need to be. Granted, you may have to adjust these figures as interest rates and auto prices change, but saving money that earns interest is a lot less painful than spending money on which you have to pay interest.
Where Should These Funds Be Saved?
I am a big fan of using one of the online banks to set these kinds of funds aside. A website with the catchy name Canadian High Interest Savings Bank Accounts has a regularly updated list of accounts, many of which currently offer well above 3% for your deposits. These can be held in non-registered or Tax-Free Savings Accounts. Setting these accounts aside from your regular spending can help you to keep them free from being encroached on by your regular spending needs.
These suggestions take a degree of planning that many of us may not be used to doing. While it may be a challenge to get started, I can imagine that anticipating a vacation, for example, with the knowledge that the money is there will make the trip a lot less stressful and a lot more fun.
This is the 187th blog post for Russ Writes, first published on 2023-03-06
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.