Nov 05

What do you do? Save money for an emergency, when rates on savings are now well below 1%, or pay off the debt, especially credit card debt which can be at or above 30% per year?

Two schools of thought, one vocal one suggesting it’s irresponsible to forgo an emergency fund, the other, telling us to kill that debt ASAP. One well known advocate in the “emergency fund camp” is Dave Ramsey. He advocates saving a $1000 emergency fund and not rely on your credit cards for an emergency. This may sound nice, but I’ll suggest you look at this a different way. When you owe money, the next dollar you’d put to another use is costing you the highest rate you pay. So if your credit cards range from 12% to 24%, and your payoff plan has 4 years to go, that $1,000 sitting in the emergency fund earning you nothing is really costing you nearly $2000 by the time the last $1000 is paid off. A cumulative 100% interest. (Get a calculator and multiply 1.18*1.18*1.18*1.18 for four years’ interest.) During this time of going after your debt with a vengeance, you should carefully monitor your available credit, and make sure you have enough credit to get you through a potential emergency. Every individual has a unique situation, so the exact cost or savings will be different for you. The goal is the same, to stop paying interest and start earning it.

written by Joe \\ tags: , , , , ,

12 Responses to “Pay Debt or Build Emergency Fund?”

  1. John Says:

    I would think it also depends on what kind of debt you are proposing paying down. I feel Credit Cards should be paid down, in fact I pay mine off every month.
    However, paying off other debt like car loans, or mortgages, or student loans just to name a few, instead of saving an emergency fund might not be right for some people, yet work perfectly fine for others. If a person (or family) has a Line of Credit maybe they consider that their “emergency fund”.
    The key, as you stated, is that there isn’t just one answer, but that it is something people should consider.

  2. Evan Says:

    Joe,

    I am in the camp someone should have much more than the $1,000 emergency fund before they start attacking debt. Notwithstanding those feelings, I just calculated how much interest I was paying per month – IT IS SCARY!

    http://www.myjourneytomillions.com/articles/interest-pay-financing-companies-banks/

    Might make want to invade my ING earning a measly 1.3%

  3. Monica O'Brien Says:

    Interesting post and question. I think it makes more sense to pay down your debts. An emergency fund of $1000 is some serious insurance on the idea that something “might” come up. Why not pay $1000 down and IF something happens, then the worse thing you do is put that $1000 back on your credit card?

    Like John, I pay off my credit cards every month in full. I’m not a fan of having credit card debt – did that once and it was one of the most miserable periods of my life. Now that the debt is gone I will do whatever it takes to stay out of that position, even if it means forgoing an emergency fund when money is tight.

  4. Augustine Says:

    I’d say that the problem with both approaches is that they’re posed as either one or the other. However, I see no problem with applying both one and the other.

  5. Michael Harr @ Wealth...Uncomplicated Says:

    This is always an interesting question. If you’re a math guy or gal, you’ll opt to skip the emergency fund because the math tells you you’re going to save money and get out of debt faster. If you’re an experienced pragmatist, you’ll opt to keep the $1,000 or more for emergencies.

    What Ramsey advocates has everything to do with behavior and nothing to do with mathematics. In a post I wrote awhile back, I posited that those following his teachings were far more likely to get out of debt and be successful in the future because of the behavioral shift that his methods create. Escaping the calculator and dealing with the ‘person-al’ part of personal finance is the key.

    Nice topic…always a good question.

    On a related note, remember when Suze Orman shifted her position on this? In the end, there are many schools of thought, if you subscribe to any of them and execute, you’ll be fine.

  6. Adam@RabbitFunds Says:

    This is an excellent question and one that I have posed to myself a number of times. I have a small amount of debt that I’m trying to finish paying off but I also maintain the $1000 emergency fund that Dave recommends. When I first heard Dave talk about saving $1000 before paying off debt I also thought, “Well that doesn’t make mathematical sense.” However, as @Michael points out, it makes a ton of behavioral sense. It helps build discipline. But more importantly, it helps avoid additional debt. For example, if I have $1000 in the bank and my car breaks down, then I have cash reserves to pay to fix it and I don’t have to charge it on the very credit card I’m trying to pay off.

    So although the math says pay off debt first, behavior and life happening suggests that a small emergency fund makes a lot of sense.

  7. Bucksome Boomer Says:

    I believe in having a small emergency fund while paying down debt. Yes, you could put an emergency cost on plastic, but might end up paying interest on it before getting it paid off.

    It’s better to have the small emergency fund of $500 or $1000 and not have to worry about adding more debt if the water heater goes out.

  8. JOE Says:

    I’m still having mixed thoughts on this. That $1000 is costing you year after year of interest until the emergency happens or the cards are paid off.

  9. Michael Harr @ Wealth...Uncomplicated Says:

    @Joe – think of it like this. The $1,000 is an education expense in the sense that you are paying a little extra interest annually to establish a habit that will return many, many times the interest expense. If you don’t have the $1,000 and just go back to a credit card, you’ve done nothing to change the habit of relying on credit cards.

    Another point of clarification on the $1,000 as it relates to Dave Ramsey. Before you set aside the baby emergency fund, a plastectomy has already occurred. The simple act of cutting up the plastic and making a vow to never go there again is backed by the $1,000 because if you limit your resources, you will naturally be more resourceful.

    To support this last point, I offer up the fact that many seniors live on a fixed income. They know what their resources are and they must manage them as best they can to ensure they don’t end up homeless. While we all know that the average retirement nest egg is horribly small, these fixed income retirees make it work.

    The same is true for those trying to get out of debt. The best way to get out of a hole is to stop digging (plastectomy), throw away the shovel (never use it again), and start the new habit of climbing (even if it’s at a snail’s pace) out of the hole.

    It’s all behavior and almost no math…the same could be said of personal finance in general.

  10. Augustine Says:

    Joe,

    If one does end up having an unforeseen expense and charges it because one didn’t save for a rainy day, wouldn’t it end up costing the same as foregoing extra payments in order to save? After all, the new balance will require higher service costs any way.

  11. JOE Says:

    Yes, only if the ‘emergency’ actually occurs. For every month there’s no issue, that savings adds up.

  12. Augustine Says:

    However, emergencies occur all the time, such as new tires, a car problem, a sick pet, etc. I don’t think that it’s realistic to discuss this subject as if someone actually goes a year without any emergency. And in the case that nothing was saved, they’ll only compound the credit card debt and increase the minimum payment, keeping the debtor in the debt treadmill by making it harder for him to save.

    Finally, the emergency fund can also accrue interest.

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