Emergency Funds and the Future Self

In 2011, behavioral psychologist Hal Hershfield and his team at Stanford University made an interesting discovery. Human brains react similarly when thinking about strangers and our future self.

Hershfield wrote, “Although this is oversimplified, the general idea is the following: People are inherently self-interested, and often act in ways that benefit themselves over strangers. And, if in fact, the future self feels like or seems like a stranger, then it may make sense to place more weight on the present over the future when making decisions that have consequences.”

This finding has massive implications for the financial world. It helps explain why setting aside an emergency fund can be so challenging.

Let’s be honest, saving an emergency fund sounds kind of boring. Most smart financial decisions are. The key is having the discipline to save for a rainy day instead of spending that potential nest egg in the present.

An emergency fund is money specifically put aside to support yourself and your family after sudden changes to your income or expenses. Being laid off, health problems that prevent you from working, and car repairs are all situations when you might dip into your emergency fund.

An emergency fund differs from other types of savings in one key way. You don’t invest your emergency fund.

Why? Because you want this money readily available when you need it.

Investing increases risk, and as a result, can decrease the funds you have available in an emergency.

Even safe investment options can penalize investors for accessing their money. Take Guaranteed Income Certificates (GIC) for example. These investments are considered low risk because banks and companies ensure a rate of return to investors. But, there’s a catch. There are often penalties for removing your investment early, which can reduce the balance of your emergency fund if you need to access the money unexpectedly.

The best place to put your emergency fund is a savings account. I know it’s boring, but it’s effective.

Try to find a savings account that has zero or very low fees, no service charges, and a competitive interest rate. These accounts will give you small returns but ensure your emergency fund is available in full when you need it.

Tax Free Savings Accounts (TFSA) are an exception. There is a limit on how much you can contribute to your TFSA yearly and these contributions should generally be reserved for long- term investments.

How much should you put in your emergency fund?

Three months’ worth of expenses (not income) is a good sweet spot. This amount will ensure that you have a quarter-year buffer to deal with the situation that required you to dip into your emergency fund.

A common follow-up question is whether you should pay off debts before starting an emergency fund to avoid costly interest payments.

The simple answer is no. Emergencies happen and you need funds set aside to deal with them.

The more complex answer is it depends on the debts you have and your broader financial situation. If you are carrying high interest debts, such as credit card debt, it may make sense to pay these off before saving your entire emergency fund.

A good rule of thumb is to start by saving $1,000 for emergencies. Once this is done, you can devote more of your money to paying off high interest debt.

It might be tempting if you have a line of credit to avoid setting aside an emergency fund altogether. This strategy can be problematic. Access to a line of credit can solve immediate financial emergencies but will likely compound financial problems over time because you have to pay off this debt and interest along with it.

Although our brain is wired to live in the present moment, there is no good substitute for putting money into an emergency fund. It is a necessary, albeit relatively unexciting aspect of financial planning. Your present self will not benefit from an emergency fund, but your future self will certainly thank you if a crisis arises. And ultimately, even though they may seem like a distant stranger, you are both playing on the same team.