Good morning my friends!
This week marked the official end of the Canadian tax season. If you delayed until Wednesday to have your taxes completed, then kudos from me — that’s quite the level of patience.
Take your pick.
This week marks Step #2 in the “Where Should I Start?” discussion. Last week, we talked about paying off your highest cost debts first. Building an emergency fund is the second step and is pretty important. However, this is easily the most tedious and annoying part of any financial journey.
But first, some quick thoughts and links.
Quick Thought of the Week
The first $10,000 is the hardest. The first $100,000 is the hardest. The first $1,000,000 is the hardest.
My boss, friend, and mentor mentioned this to me this week. He was talking about a story long ago in which he had the chance to talk finances with a multi-millionaire from his local community. That gentleman had said, quite simply, that the first $1,000,000 was the hardest to make. After that, it felt like another million showed up every few years.
The first $10,000 is the hardest.
Though we’ve discussed Tip #4 from Robert Kiyosaki already, the other three tips from Rockefeller, Clason, and Ramsey are all good pieces of advice to have in your back pocket.
Of course, each of these tips, though easy on the outside, have some nuance the further you delve into the matter.
I’m excited to talk about these over the course of time.
How to Save an Emergency Fund
After you’ve paid off your high-interest-rate debts, the best advice is to save an emergency fund.Nearly all personal finance advisers recommend saving a cash emergency fund, as it’s better to use your own cash to live should a rainy day strike than go into debilitating debt to get through.
Ideally an emergency fund is never used, but staves off the risk of losing your job, having an unexpected vehicle repair, or having unexpected medical bills. As a result though, the emergency fund can turn into one of your poorest returning assets if managed incorrectly:
- Emergency funds need to be held in an accessible account (a cash account you can access within 24 hours), which limits the rates of return you’ll realize.
- Emergency funds need to be held as cash (or near cash equivalents (something that can be turned into cash nearly immediately)) and cash has a negative growth rate due to inflation.
- Emergency funds are likely to be a never-ending, impossible-to-achieve goal, as the fund needs to grow as your income and spending grows.
I have a few thoughts about how to mitigate some of these shortcomings.
How Much to Save in an Emergency Fund and How to Calculate the Amount
In general, it’s recommended to save four to six months worth of expenses in an emergency fund. Four to six months of expenses is going to differ for everyone, and how you calculate that number is also going to be different for everyone. So, first, we need to go through a beginner’s primer on fixed and variable costs.
Fixed costs are costs that do not change based on your activity. Fixed costs cannot be avoided. These are things like rent payments, vehicle payments, groceries, dependent expenses, or utilities like water or electricity. I also think internet and cell phone bills are fixed costs these days, as these two services continue to entrench themselves increasingly in our lives.
Variable costs are costs that change based on what and how much you’re doing. Expenses like fuel, dining out, travel, alcohol, gifts, and most types of monthly subscriptions would qualify as variable expenses.
Another element to consider in the fixed and variable cost discussion: how easy is it to cut out the expense? It’s difficult to cancel your rent payment or the weekly grocery bill, but it’s quite easy to cancel a Netflix subscription.
I believe you need to build your emergency fund to cover all your fixed costs plus a few of the hardest-to-cancel variable costs plus at least some entertainment costs. Quite simply, if you lose your job, the very first thing you’re going to do is look at expenses you can cut out to save some cash. The idea of saving extra cash to cover all your variable costs makes achieving an emergency fund that much more difficult, and represents an expensive opportunity cost in holding that much additional cash. (Opportunity costs, in the easiest terms, are the total costs of missed opportunities were you to invest the cash in something else.) And no matter what, you need to have some fun once per month to ensure you maintain sanity.
I also don’t think you should be saving four to six months worth of fixed-plus-some-variable expenses. This is far too much and doesn’t reflect the realities of social security networks these days. (Need proof? Look at how most governments around the world have helped their societies get through the COVID-19 pandemic.)
The more cash you save in an emergency fund means the more cash you’re not able to use in higher-return investments or for saving for a home.
Don’t overdo the emergency fund.
Save 2 to 3 months of expenses maximum in your emergency fund. Maybe even consider 1.5 to 2.5 months worth of expenses.
To offset the risk, there are a few things I think most common people would undertake if they lose their job:
- Look for paid work on the side while waiting for a job opportunity to arise.
- Apply for employment insurance benefits.
- Look for superfluous, easy-to-cut expenses to eliminate.
- Eat at home as often as possible.
By making a range of these decisions while unemployed, you can cut down on the required size of your emergency fund and employ more cash in higher-return investments.
Here’s an example list of expenses you may find yourself calculating for one month:
- Rent: $1,000
- Utilities: $250
- Groceries: $150/week x 4 weeks = $600
- Vehicle Payment: $500
- Fuel: $200
- Vehicle Insurance: $150
- Dependent Expenses: $150
- Miscellaneous Variable Expenses: $100
Total monthly expenses: $2,950.
Two to three months in an emergency fund: $5,900 to $8,850.
Adjust as needed (especially that vehicle payment amount).
How to Actually Save the Emergency Fund
If one were to go and save, say, 10% of their paycheque every month to build an emergency fund while earning the Canadian average salary of $51,000 (2017 numbers), it would take approximately 55 months (4.5 years!) to save $7,500 in an emergency fund.
That’s ridiculous. That’s way too long to wait to get started on building savings for higher-return investments.
Yet, I don’t have an overly good answer on how to build that emergency fund as fast as possible. These first savings steps are by far the hardest steps in the wealth building process. This step is the least gratifying and most tedious step I can think of. I hated saving an emergency fund.
So, a couple ideas:
- If you’re coming out of post-secondary, it’s quite likely you’ll have tuition and education credits you can use on your tax return. Use the corresponding refund to build your emergency account.
- If you’re a recipient of a gift, save that gift in your emergency account.
- If you have an extra vehicle, or extra assets from post secondary you no longer need, sell those assets and save in your emergency account.
- Borrow from a low interest line of credit to instantly fund your emergency account, and focus on paying off that line of credit.
This last idea is the one I utilized and I’m unsure whether to be proud or ashamed to admit it. I know myself: I’m better at paying debt off than putting cash in a savings account. So, I borrowed from a low interest line of credit, funded the entire emergency account in a day, and immediately began paying off that line of credit. I found this was faster than trying to save, say, 10% or 15% of each paycheque.
I know this method carries an interest cost each month, but hear me out: By saving the emergency account quicker, I was able to get into higher-return investments faster. I believe the costs are offset by the returns, especially so after those investments have been alive for 30 years.
Whichever way you decide to tackle saving this emergency fund, I wish you well — this is, in my opinion, the worst and hardest part of getting started.
Remember the Cost of Keeping Too Much Cash
Cash has a negative growth rate — inflation eats into the value of cash at anywhere between 0.5% to 2% or more per year. In order to ensure your cash is at least keeping up with inflation, you need to keep the cash in a savings account with an after-tax rate greater than inflation. Multiply your savings interest rate by 70% or 75% to get to a real savings rate number, and that number has to be greater than inflation.
That’s very hard to do.
Therefore, I have one major recommendation:
Never stop saving and building your emergency fund.
Once you have saved the bare minimum in your emergency fund, you should get started on saving for higher-return investments. But you should always continue to supplement that emergency fund to ensure it contains enough cash for a rainy day.
Continue building your emergency fund for two reasons:
- As mentioned above, it’s unlikely you can keep your cash in an accessible account and find an after-tax interest rate that’s greater than inflation. It’s possible, but it’s difficult, especially at Canada’s big banks. Keep supplementing that emergency fund to overcome the cost of inflation.
- Your income is going to rise over time, and so your fixed and variable costs are going to rise over time as well. Everybody increases their lifestyle to match their earnings. This, plus the fact all expenses increase through inflation, ensure a never-ending need to increase your emergency fund.
Put another way, the emergency fund is a moving target that constantly needs to grow over time, carries an expensive cost because of inflation, and is the hardest element of getting started when building wealth.
Emergency funds suck.
My emergency fund rule of thumb: Determine an amount you’d be comfortable with should a rainy day take place, and save slightly less than that amount.
The lesser amount will lower the cost of keeping cash, shorten the amount of time it takes for you to save the emergency fund, and most importantly, will ensure a fire is lit under your butt to supplement your life if a rainy day comes your way.
I appreciate you making it through Part #2. Next week, we’ll discuss why renting for a longer time than you might hope will help build your down payment and get you off on the right foot for years to come.
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I hope you have a fantastic weekend ahead of Thanksgiving weekend. The summer has come and gone and fall is getting fully underway.
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