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An unexpected medical bill, a sudden job loss, or an unforeseen home repair: life has its surprises. For many Canadians, these surprises can lead to financial stress. 

Consider a February 2023 report from Statistics Canada: 26%, or around one in four Canadians find themselves ill-equipped to handle an unexpected $500 expense. 

Moreover, in the fall of 2022, a concerning 35% of Canadians admitted that their household struggled to meet financial demands over the prior year. 

Such statistics underscore the pressing need for a financial safety net. An emergency fund, especially a tiered one, not only acts as a buffer against these unexpected financial shocks but also aids in managing and paying down debt

For Canadians unfamiliar with this concept, establishing an emergency fund might seem challenging. But fear not – this guide offers a robust strategy to kickstart your journey towards financial resilience.

How Can A Tiered Emergency Fund Help You Manage Debt?

At its core, an emergency fund is a savings buffer designed to cover unexpected expenses without needing to resort to debt.

When unforeseen expenses arise, many individuals are compelled to resort to credit cards or loans to cover the costs. 

This immediate solution, while convenient, can result in accumulating unnecessary debt. Over time, interest on this debt can compound, leading to a financial burden that spirals out of control. 

Having an emergency fund in place can prevent this scenario. By tapping into your savings to cover unexpected costs, you avoid accumulating high-interest debt and save yourself from the long-term financial consequences.

Moreover, life’s more significant challenges, like job loss or illness, can pose not just emotional but financial strain as well. Imagine being without a steady income source but still having monthly debt payments to honor. 

It’s here that an emergency fund shows its true value. With savings set aside, you can continue making your debt payments without incurring additional liabilities. 

This lessens your financial pressure considerably, allowing you to focus your energies on recovery and getting your life back in order.

What Is A Tiered Emergency Fund?

Banks in the U.S. have a smart way of keeping their money safe. They split their money into different groups or ‘tiers’ as a form of risk management. 

Think of it like having different pockets in a big wallet. Each pocket is for a different kind of situation. Some pockets are for small problems and others are for big emergencies. This helps banks be ready for any surprise, big or small. 

We can do the same thing with our savings. Imagine you have three jars:

  1. Jar 1: For small surprises like a flat tire or a broken phone.
  2. Jar 2: For bigger things like if you lose your job and need to pay bills for a few months.
  3. Jar 3: For really big emergencies, like a serious illness.

By having these jars or ‘tiers’, we’re ready for anything life throws at us, just like the banks. It’s a smart way to keep our emergency money safe and ready for any situation.

The Different Tiers of Capital In Your Emergency Fund

Tier 1: Chequing Account

Purpose: The primary goal of this tier is to provide instant access to funds for minor unexpected expenses, such as a sudden car repair or an unexpected medical bill. Think of this as your ‘immediate response’ reserve, meant to address situations that need attention right away without the need to transfer money or access another account.

Type of Account: A checking account is ideal for this purpose due to its high liquidity.

How Much to Save: Ideally, you’d want to save up to one month’s worth of your typical expenses in this tier.

Tier 2: High-Interest Savings Account (HISA)

Savings Goal/Purpose: This tier acts as a cushion for more prolonged financial disruptions that might last for several months, such as extended illness or a temporary job loss. The benefit of a HISA is that while your money remains relatively accessible, it also earns a decent amount of interest.

Type of Account: A High-Interest Savings Account, which offers better interest while still ensuring good liquidity. 

How Much to Save: Aim for three to six months’ worth of living expenses in this tier. This allows you to manage medium-term financial challenges without resorting to debt.

Tier 3: Investments and Non-Liquid Assets

Savings Goal/Purpose: This tier is for significant, life-altering events that have long-term implications, like a permanent job loss or a serious health issue that prevents one from working for an extended period.

Type of Account: Investment accounts or non-liquid assets such as stocks, bonds, or funds in a Tax-Free Savings Account (TFSA), or Registered Retirement Savings Plan (RRSP)

How Much to Save: There isn’t a fixed amount, but it should be a substantial portion of your overall wealth that can cover up to at least a full year of living expenses. Keep in mind that these assets might be harder to sell, may incur taxes upon withdrawal, and using them could alter your long-term retirement plans.

Tier 4: Line of Credit

Savings Goal/Purpose: If all other tiers are depleted or unavailable for some reason, a line of credit can act as a final safety net. It’s a borrowed resource, but it’s designed for emergencies and is usually more affordable than credit card debt.

Type of Account: A line of credit, potentially secured against assets like your home for better interest rates.

How Much to Access: This depends on your creditworthiness and the assets you can leverage. While it’s better than resorting to high-interest credit cards, always remember that this is borrowed money that will need to be repaid. Utilize it judiciously and as a last resort.

How To Build Your Tiered Emergency Fund

Building a tiered emergency fund is a deliberate exercise that demands both strategy and discipline. Here are some approaches to bolster this financial safety net effectively.

Create A Budget

At its core, budgeting revolves around a straightforward formula: Net income minus expenses equals savings or, unfortunately in some cases, debt. 

To illustrate, consider Jamie, who earns $3,000 monthly. After accounting for rent, groceries, utilities, and other essentials, Jamie incurs expenses amounting to $2,200. 

This leaves Jamie with $800, which can be channelled into savings or debt repayment. With a budget, Jamie gains transparency into where every dollar goes. 

The clarity provided by a disciplined budget serves as a check against frivolous spending.

Automate Savings

Consistency is key to growing an emergency fund. To ensure that a portion of your income regularly flows into this reservoir, set up automatic transfers from your main account to your emergency fund. 

By doing so, you’re essentially treating your savings as a non-negotiable, mandatory expense. Periodically, it’s essential to monitor the levels in each tier of your fund to ensure that you’re maintaining the desired balance.

Review and Adjust

Whether it’s a change in income, unexpected expenses, or major life events like marriage or the birth of a child, it’s vital to revisit your emergency fund contributions. 

Adjust them as necessary to reflect your current situation and future expectations. Be sure to keep your estimates conservative and err on the side of caution.

Moreover, akin to banks that conduct simulations to gauge their resilience against potential financial downturns, it’s a good practice to periodically ‘stress test‘ your own emergency fund. 

For instance, simulate a hypothetical scenario like a medical emergency, project its associated costs, and assess the impact on a particular tier of your fund. Does it significantly deplete that tier? Does the expenditure overflow to the subsequent tier?

Avoid Temptation

Remember, your emergency fund is not a piggy bank meant for random withdrawals. It’s a financial safety net to cushion genuine emergencies. 

Succumbing to the temptation of using it for non-urgent expenses can erode your fund faster than you might anticipate.

Conclusion

Having a buffer against unforeseen financial setbacks not only offers peace of mind but can also be the difference between temporary hardship and spiralling into debt.

Moreover, adopting a tiered approach to building this fund amplifies its benefits, providing different layers of security, growth, and accessibility.

For Canadians, whether just embarking on their financial journey or seeking to fortify their safety nets, now is the time to consider or refine an emergency fund with a multi-tiered structure. 

So, where to start? Take a look at your personal finance landscape, and set clear and attainable goals for each tier. 

And remember, as you navigate this journey, especially when considering tools like lines of credit, shopping around can make a world of difference. 

Seek out the best deals, terms, and rates to ensure that your emergency fund is not just robust, but also optimized for your unique needs.

Savings Fund FAQs

How much should you have in your emergency fund?

Determining the ideal amount for your emergency fund primarily hinges on your personal budget. Begin by calculating your monthly expenses.  Once you have a clear picture of your regular outgoings, you can figure out how much should be allocated to each tier in dollar terms.  As a general guideline, you might consider having a month’s worth of expenses in Tier 1, three to six months in Tier 2, and up to a year or even more in Tier 3. As for Tier 4, it should be based on the amount you can secure as a line of credit at a reasonable interest rate.

Should you build an emergency fund or pay off your debt first?

The answer often depends on the nature and interest rate of the debt in question.  If you only have easily manageable debt, like a mortgage that you have already budgeted monthly payments for, it may be worth focusing on building your emergency fund first. The same idea might apply to low or interest-free student loan debt.  However, when it comes to high-interest liabilities, such as credit card debt, prioritizing its settlement is crucial. Tackling such debt head-on with any surplus from your budget can save you significant amounts in the long run.

When is it a good idea to use my emergency fund to pay debt?

A practical approach would be to compare the interest rate on your debt to the potential returns from a risk-free instrument like a high-interest savings account (HISA).  If the debt’s interest rate is higher than what you can earn risk-free in a HISA, it might be financially smart to deploy your emergency fund to offset that debt.  The reason? The cost of carrying that debt (in terms of interest) is likely outpacing the benefits accrued from your savings, making it sensible to pay down the debt promptly.

Tony Dong avatar on Loans Canada
Tony Dong

Tony started investing during the 2017 marijuana stock bubble. After incurring some hilarious losses on various poor stock picks, he now adheres to Bogleheads-style passive investing strategies using index ETFs. Tony graduated in 2023 from Columbia University with a Master's degree in risk management. His investing qualifications include the Canadian Securities Institute's Canadian Securities and Equity Trading & Sales course(s), Franklin Templeton's Canadian ETF Proficiency course, Bloomberg Market Concepts, CFA Investment Foundations, and McGill University's Personal Finance Essentials. His work has also appeared in U.S. News & World Report, USA Today, NYSE ETF Central, NASDAQ Fundinsight, Cboe ETF Market, TheStreet, The Motley Fool, and Benzinga.

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