Do you need three-month’s salary as an emergency reserve?

It is conventional wisdom and practice in Canada to set aside 3-6 months of salary as a cash (or near-cash) reserve in case there are unexpected emergencies or issues which crop up in life.  And crop up they will!  But while likely everybody will agree that it is wise to have a reserve available for when it’s needed, not all agree on what that reserve should look like or where it should be.

How Much Do I Think I Need?

Let’s say I make $5,000 per month and feel a five month reserve is sufficient for what may be thrown my way – maybe a loss of employment that I need to prepare for.  A five month buffer is comfortable to me as I believe I should well be able to find new work before that five month reserve is depleted.  What this means is that I will have $25,000 in cash sitting in a bank (maybe high-interest savings account at 2%).

I love to look at the bank statement and see that $25,000 balance.  It is comforting.  It allows me to sleep at night.   I know I can simply trot down to the bank and get my hands on it any time I want.  I feel good knowing I am safe.  But what is it costing me?  Yes, it actually costs me – having that $25,000 sitting in cash earning next to nothing means you are likely losing out to the cost of inflation.  So that $25,000 today is valued less than $25,000 one year from now.  And even less two years from now…

But I Also Have a Mortgage

Meanwhile, I have a mortgage.  A big, burdensome mortgage that costs me a fortune.  Not only does it take a couple thousand off my pay cheque each month, but the majority of the payment I make doesn’t even go toward my benefit in the least.  The amount I pay in interest goes directly to the bank as payment for me renting their money.  And insult to injury, this great amount of interest I pay each month is not even tax deductible.  Plus, any mortgage payment – both principal and interest components – is made with after-tax dollars.

So what am I getting at?  There is a better way to deal with your 3-6 months ‘emergency reserve’ requirement than hoarding that money in a bank account in case you ever need it.  I’m going to take that $25,000 I already have saved up and make a prepayment against my mortgage, then re-borrow it to invest in real, growth-oriented assets to allow me to take advantage of newly-created tax deductions and the magic of compound growth.  For example, what’s that $25,000 at 2% in the HISA worth in 10 years?  Just over $30,000.  And if I am able to prepay my mortgage by that $25,000 tomorrow and get back at it to invest at 8%?  In 10 years it will be worth just under $54,000.  A big difference.  And that does not include the tax deductions that you will now start to earn.

You Don’t Pay For It If You Don’t Use It

But what about the emergency reserve?  If I have invested that $25,000 after running it through my mortgage (thereby reducing the time it takes to pay it out and also generating tax deductions) then isn’t it locked up?  Yes and no.  You could redeem $25,000 of assets or whatever amount you required for the emergency, pay tax (but only because you’ve made money) and take care of it that way, but you may consider leaving it invested for the long-term and simply having a personal line of credit on hand for emergencies.  You don’t pay for it if you don’t use it; and if you have to, you will make the decision to pay it back over time or quickly with the investment assets at your disposal.

Get that ‘emergency reserve’ working for you by reducing the time you’ll have expensive, non-deductible, mortgage payments, generating tax deductions, and earning a real rate of return by investing for your your future.