Emergency Fund vs. Debt Snowball: What’s the Top Priority?
Published on - November 15th, 2010 (by Sierra Black) This post is from staff writer Sierra Black. Sierra writes about frugality, sustainable living, and getting her kids to eat kale at Childwild.com.
A few weeks ago, in my review of Mary Hunt’s Debt-Proof Your Marriage, I mentioned that she advocates building a 3-6 month emergency fund before beginning to snowball your debt payments. That’s not my approach, and I criticized it a little in my review.
Several commenters said they agreed with Hunt — that an emergency fund should trump debt repayment. It’s an interesting issue, so I figured I’d explore both sides of it in a little more depth.
The Case For An Emergency Fund
The primary case for an emergency fund is simple: Having savings helps you break the cycle of debt. When your car breaks down, you won’t have to rely on a credit card to get your wheels back on the road. You’ll have your own savings to fall back on.
There’s also a more subtle reason to do it. Saving money is at least as much about your state of mind as it is about your income and expenses. If you can get into the habit of saving a chunk of your income — 10% to 20% is what most experts recommend — you’ll be well on the road to financial health. Adopting the “pay yourself first” strategy is one of the keys to personal finance.
Treating your credit card bills like any other household expense while paying yourself first makes good psychological sense. But you’ll pay for it with interest.
The Case For The Debt Snowball
If, instead of putting your eggs into your own basket, you pay off your debts faster, you pay less interest on those debts. Even the best high-interest savings account is unlikely to get you an interest rate anywhere close to what your credit card charges. Odds are good that the interest you pay on those card balances is a whole order of magnitude greater than the interest you earn on your savings.
Over your lifetime, that means you’ll have more total money if you pay off the high-interest debt first and then build up your savings.
But that only works if you get out of debt and stay out of debt. If small emergencies force you to break out your plastic every couple of months, you may just be treading water instead of turning the tide.
Taking The Middle Road
One good approach is to take a hybrid of these two: Build a small emergency fund first, and then pay down your debts as aggressively as possible. Dave Ramsey recommends putting $1,000 into savings before tackling debt. What you want is enough to cover a small emergency like a car repair or a plane ticket, but not a full 3-6 months of living expenses.
This is essentially what I did last year. I saved $1,000 in a savings account, and then began snowballing my debts. I also used the increase in our income after I returned to work to feed that debt snowball, and was able to repay a lot of debt fairly quickly.
Building up a small emergency fund and then aggressively paying off debts seems like a good middle road, but it’s not without potholes.
At the beginning of our debt-payoff period, my husband and I weren’t quite on the same page about our financial changes. Neither of us was used to living within our means. It was a great idea, but it took some practice to get good at tracking our spending and sticking to our budget. There were times we’d come up short at the end of the month.
Having a small emergency fund sitting there was like a fight waiting to happen. Couldn’t we just take the money out of savings to cover this plane ticket? Or that gymnastics class? It turned out that, at the beginning of our debt repayment, we hadn’t moved into the mindset of saving yet!
For us, paying off the debts faster and staying in the risky position of having no safety net worked better psychologically. Paying off debt was something we could agree on. And once the money had been sent to the credit card company, there was no bickering over what to do with it.
Handling Emergencies Without A Full Emergency Fund
You can’t plan for emergencies; that’s the nature of them. You can find creative ways to handle them, though. While my emergency fund hasn’t grown beyond that initial $1,000, I’ve been able to handle all of the small emergencies that have come up in the past year without taking on any new debt.
One thing I’ve found is that, as my expenses have dropped and my income has increased, I have more money available. Most months, I use it to pay down our debts. When an unusual expense crops up, I can dip into my debt snowball to cover it. I’ve never had to touch our emergency fund yet.
This month, for example, my laptop needed major repairs. I could have tapped my emergency fund for the $300 to cover it, but instead I took it out of my regular checking account and simply scaled back my debt snowball a little (though not by $300; I also took money out of my entertainment budget to cover this).
Do What Works For You
Having a small savings fund to draw upon is definitely key to breaking the cycle of debt. You need to create enough of a buffer in your budget to absorb hits like car repairs, appliances breaking down, and health issues cropping up.
Beyond that, you need to do what works for you. If establishing the habit of “paying yourself first” is your top priority, setting up a weekly savings deposit and building that emergency fund might be your best course, even though it means paying a little more in interest over your lifetime.
If you’re completely driven to get out of debt, you may do better to snowball your debts first and pay them off fast.
Ultimately, you need to do both: Eliminate your consumer debt and build an emergency fund. The order you do these steps in matters less than living out a commitment to establishing sound financial health.
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When I was fighting off my debt about 2 years ago, I went with a hybrid approach between the e-fund and the debt payments. Essentially, I did an 80/20 split. The result was, once I finished my debt off, I already had a healthy emergency fund growing and ready in case anything bad happened.
The peace of mind it offered was essential to paying off my debt quickly and aggressively.
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I think some of the confusion here is over the terms used.
I think of emergency funds as being immdiately available reserves capable of covering costs of a appliance/car break down. At most a few £1000.
I’d considered money used to cover a period of unemployment as something very different in that you would need to cover a larger amount spread over a longer term. Personally I consider that to be part of general savings, although it maybe put aside in a different savings account so it doesn’t get spent on anything.
I would absolutely have an emergency fund put away before really going after debt, but the general savings would be added to slowly while paying off the debt.
Trevor
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Since we’ve decided to save for a wedding, I’ve cut my debt snowball down to a measly extra $50/mo. I tend more towards paying debts with a minimum savings. I think the most my savings ever got to was $3k before I took $2k of it for my debt repayment. It’s definitely hard for me, because I look at the money in savings and think that if I just threw it at my student loans, I’d save $XXX in interest.
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Hybrid, I have found paying down debt easier than savings. Watching the balances drop on our debt is much more exciting. We established a small emergency fund, which we did tap twice during our 12 and half month debt killing project (once for an A/C repair and once for a car repair).
I’d like to hear more about why the author of the book suggests 3-6 mo. emergency fund before addressing unsecured debt?
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I think the emergency fund takes precedence. The emergency fund gives you a piece of mind knowing that you remain afloat during big crises (job loss, illness, disability) and take care of issues quickly during small crises (auto issues, appliance replacement). Without the e-fund, all situation become a crisis. Ideally, a minimal e-fund (3 months) should be built up before attacking debt, and once that 3 months is established, a split between the e-fund and the debt snowball (I’d say 50/50 until a full e-fund is established) helps to accomplish both goals while minimizing risk.
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My wife and I approached it by taking our income, reducing it by tithing, expenses, bills, and a monthly spending allowance. The excess we split equally into three categories.
1) Debt Payoff
2) Emergency Fund
3) Retirement / Home downpayment
– 2/3 into a retirement account
– 1/3 into a savings account for a downpayment
The debt payoff will snowball until all of our debt is paid off in about three years (>$100k) and the emergency fund will be about 8 months of my wife’s pay for now (I am military). The retirement is split as we consider our home an investment too and putting 1/3 of our money into that will continue once we purchase a home.
It’s not fancy, but it works for us. After nearly 23 years of living paycheck to paycheck, putting 2 kids through college, and living on debt, we decided to fix all of this. 15 years to retirement (we hope)…
We just started Jan 2010, but so far this year, we have paid off our car (a year early), and 4 credit cards. It is very exciting to see our balances go down so fast and we are still living decently on our monthly budget amount without having to keep track of every penny.
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We don’t have any consumer debt so it’s easier for us to send money to the emergency fund.
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Åfter we blew through our $1000 fund three times in one summer (home repair issue, emergency surgery for one of us, and a medical problem for the other), we decided we wanted a different approach. We added to the emergency fund while paying off debts aggressively, then once we got to just the student loans and mortgage, continue to pay a little extra on those while increasing our emergency fund more aggressively.
For now, this approach works for us and am glad we took this approach. I will be out of a job in 6 months and while there are nibbles, we may need that money to live on.
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I do think psychological motivations are important. And some things work better for some people. For me, it made a big difference what kind of debt it was. A credit card might be charging 16%, or even up to 26%. Those just have to go, so it makes sense to keep only a very small emergency fund and put everything to those. However, a car loan or a student loan at 5% is a different animal. If your only recourse in emerrgency is a credit card with a crazy interest rate, then it makes sense to let the low interest loans ride while you stash some cash somewhere. I recently tapped my emergency fund to the tune of $2500 which I had built up before I had just starting to pay off extra on my car loan. I could have used a credit card, but that would have been alot more $$$ in the end. Also, my emergency wasn’t really an emergency, frankly, because I had built into my equations that extra expenses do pop up from time to time. My car money every month includes an extra 100 to cover regular maintenance, smallish repairs and registration, etc. That extra $100 goes into the “emergency” pot (I know lots of people keep everything separate). I really do have all of my expenses calculated, including future moving expenses,one dental crown a year, although I have now gone several years without needed one, an emergency room visit every year, although my kids don’t need one every year — so that won’t really be an “emergency” when these things happen. Because of careful planning I haven’t “needed” to use a credit card for years. I do use one regularly, though, for the points which every other year pay for Christmas.
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Having an emergency fund, I believe is essential. During a six month period this year I had to replace my central heat and A/C that died three days before snowing, my riding lawn mower and an emergency, weekend (double rate) septic tank pump due to heavy rains. Total cost $10,725. Having the cash on hand was both peace of mind and no intrest paid on a credit card. Life happens fast sometimes.
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It really depends on how much financial wiggle room you have. If you’re living paycheck to paycheck, I say first pay off 1 debt aggressively and once that is done, use that extra money to save a small emergency fund. Once that is done, continue to do a hybrid of both.
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I guess what I’m doing is the “hybrid” path. I am not saving for a fully funded EF until we’ve paid off some other debts, but in the meantime, I save a small amount each month into the fund. Keeping money flowing into the fund has been an essential part of our debt reduction–for example, it was much less stressful for us on the rare occasions we’ve had to dig into the fund because we knew we already had money budgeted to “replace” the spent money.
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You have to look at your own situation and do what works for you. I like the approach to pay off debts first before building up the emergency fund however my situation calls for a big emergency fund. My wife has a medical condition that could land her in the hospital or out of work in a moments notice. Without our 6 month plus emergency fund, we would be up a creek without a paddle.
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So much depends upon psychological factors and life circumstances, including the really crappy economy. Years ago, all I wanted was to be out of debt. Now we are, except for our mortgage. But I think if we were still carrying student loan or credit card debt today, we would pay the minimum (or maybe a little more on credit cards), but put the bulk of our funds into savings. The economy and the very tight credit conditions make an emergency fund more important these days for people with families looking to provide stability for their children.
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Something that always confuses me is, when pundits say you should have 3-6 months of expenses in emergency savings, what are they counting as “expenses?”
A significant portion of our monthly budget is comprised of retirement savings, car replacement savings, and building the emergency fund itself.
Do I exclude those “expenses” from my monthly budget when calculating our 3-6 months of expenses, and assume we’d put those savings efforts on hold during the emergency?
It seems like that’s the assumption, but nobody ever seems to state it explicitly. Maybe it’s just too obvious?
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There are two big reasons to do the ER fund before the debt:
1) Credit card companies are, with increasing frequency, trimming credit limits down to the balance of a card. Not only does this screw up your credit (debt v available credit ratio), but it also means that you have less available for serious emergencies.
2) The economy. $1000 is a great start, but it’s not going to go very far if you lose your job. Perhaps you are in a very secure position, but that’s a risky gamble in this economic climate.
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Let me echo Sara and Mom of Five: its all about psychology.
Two years ago and for about 3 months, I did have consumer debt. I had bought a bed and some other furniture. Nothing fancy, but enough to put a big hole in my finances.
Why did I do this? I was willing to pay the interest in order to not sleep alone; my girlfriend had let me know she would no longer sleep on my cheap futon.
At the time I had the barest of emergency funds — a thousand bucks. That wouldn’t have covered rent. My monthly cash outlays were two grand a month, as I’d over rented and my student loans were on the more aggressive default approach.
I’d say whether to pay it off or build the emergency fund goes to emotional makeup. If, like me, carrying a credit card balance makes you nervous and you feel the interest payments, then by all means, pay it off as quickly as possible.
If, on the other hand, you feel more secure with the money in your pocket, go that route.
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I disagree with the author’s definition of emergencies. For example, I’ve never owned a car that didn’t need some kind of repair every year. For these irregular expenses – car maintenance, home maintenance, an invitation to an out-of-town wedding, etc. – I set money aside in a separate account.
A true emergency is a job loss, a flooded basement, a hospitalization, a totaled car… And these things require significantly more than a $1000 cushion. I go with Suze Orman on this one – since job loss has become so common, 3-6 months savings (or more!)takes higher priority to debt repayment.
If you lose your job and stop paying credit cards, you damage your credit. If you lose your job and can’t pay the mortgage, you lose your home. Secure the most important things first.
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I do a lot of contract work, so I decided on a hybrid approach. I really like Dave Ramsey’s $1000 emergency fund idea. I am a single mom, and need as much available cash as possible. When I am paying off my debts, I can’t get that money back for living expenses.
Currently, I have about 3 months expenses saved. I pay the minimum on my debts, and once I reach a lump sum to pay off the debt(for example my car), I then pay it off.
This way, if my work runs dry before I pay off my car, I can keep the money, and just continue paying the minimum while I am looking for more work.
Work has been very good lately, but I want to quickly build an 8 month emergency fund because contract consulting can be sporadic. This way is more comfortable for my situation.
Fortunately, I only owe $3000 on my car, and about $10000 on student loans. I hope to have these debts paid off by June 2011.
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I’ve come to the same conclusion Natalia! I’m a 23 y/o recent college grad with 20k in student loans (but no other debt fortunately). While I absolutely loathe the idea of being in debt, my “family” is notoriously unreliable. Thus, I don’t have the whole “I’ll just go live at home or ask Mom and Dad for money” option like most people my age seem to have. So I think I’m going to do the same thing as you; pay a little over the minimum on debt, while stashing it all the rest away for an emergency. Then in a couple years from now, when I can knock out a huge amount of debt at once, I will. I suppose if you’re not the type that can look at $10,000+ in the bank account without spending it, then this strategy may not work, but I have no doubt it will for me.
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@Kevin above: I believe the answer is that you get to determine what constitutes a month of expenses. In our case, we are working on saving 3 months of bare bones expenses. If I’m out of work we’ll stop saving for vacations, birthdays, retirement, paying cable, etc., and just pay the absolute minimum bills. If you have the financial wherewithal to be able to save 3 to 6 months of salary replacement — more power to you.
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There’s no debate: Debt trumps saving! The _only_ exception is very low to zero interest debt.
Pay $1000 off a credit card and the interest savings is the beginning of your savings AND it can be used as an emergency fund if it’s needed.
It isn’t about “what works for you”. It’s about living within your means. First, you have to know what that means. Then you have to have the will-power to do it.
Almost every penny i spend goes on a credit card. I have paid my balance in full every month for 10 years. That is, i haven’t paid any type of few to any credit card company. I do that because i know how to live within my means. But it wasn’t always the case. I used to continually carry $10K of revolving credit. Until i calculated the interest i was paying every year and realized that’d all be savings if i would just have a little will-power to not buy everything i wanted when i wanted it. That is, the will-power to live within my means.
I’m now a better consumer because i have more buying power since i’m not burdened with debt.
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Like you stated, it’s not black and white. The only debt we have is a line of credit on the house, other then the mortgage. We maintain a small emergency fund of cash, maybe a month’s worth of expenses if we stretch, and the rest goes to the line. If it’s a dire emergency and the cash doesn’t cover it, we can draw on the line again. Yes, it takes discipline defining a dire emergency. But, at the end of the day, we would have saved significantly more on interest during the period the line was lower then we would have made in a savings account.
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Kevin (#14) raised an excellent issue:
[15 November 2010 at 7:58 am
Something that always confuses me is, when pundits say you should have 3-6 months of expenses in emergency savings, what are they counting as “expenses?”
A significant portion of our monthly budget is comprised of retirement savings, car replacement savings, and building the emergency fund itself.
Do I exclude those “expenses” from my monthly budget when calculating our 3-6 months of expenses, and assume we’d put those savings efforts on hold during the emergency?]
Wouldn’t the answer to this be “Absolutely. Put those savings efforts on hold until you’ve come out the other end of the crisis. You’ll be all the better positioned afterward.”
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Deb – A month of expenses is the money you need to live for a month. Food, Shelter, Utilities, Clothing, and Transportation expenses for one month.
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Doing both is a great idea, and teaches both concepts while helping in two ways. Long term it is probably better just to pay off debt, but without an emergency fund you are just asking for more debt!
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I go with the debt repayment. I have a small emergency fund (one month expenses), but do not believe that I will need to use it.
Fortunately, my job is incredibly secure, so even in this economy I do not forsee a job loss. And as for most emergency expenses such as car repair or last minute plane ticket, I can cover that by shifting money from debt repayment for that month.
However, if I didn’t have a secure job, I would bump up my emergency fund to at least 5 months. But I still don’t see why 8 months would be required. Seems excessive.
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No suggestions here, aside from what others have said in that it’s up to each person to decide what split of savings/debt reduction they are comfortable with.
I do want to say, though, that the phrase “hits like car repairs, appliances breaking down, and health issues cropping up” really shocked me. As a Canadian, it is utterly foreign to me to think of medical emergencies in the same category as car repairs. A hospitalization might end up costing me income in the form of lost work, but barring significant time off, I cannot fathom that medical issues can keep contributing to someone’s debt load.
A body is not a car! One is a luxury and the other is not, and I know which is which.
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I think that if you have credit card debt you should put every penny towards paying those off. If you are serious about eliminating your credit card debt then every dollar you pay to the credit card company does two things 1) Reduces the amount of interest accrued 2) reduces your balance thereby allowing you to charge more money to the card in the event of an emergency. Some people might get upset at putting money on the card since you are trying to pay it off, but the math never lies, the money you save on credit card interest will be significantly more than the money you accrue in a savings account. Now this only works for those who are truly committed to paying off their debt. Its what my wife and I did and it worked wonders.
Once you get to the mortgage or student loans, then you should really have an emergency fund since paying those off does not give you access to cash in case of an emergency. As a side not, today my wife and I finished fully funding our emergency fund, and will start to look at which of our loans to target for payoff!
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I started on on the Dave Ramsey plan of a small emergency fund of $1k, debt snowball, and finally a 3-6 month expenses emergency plan.
While in the middle of the debt snowball, I got concerned about the possibility of losing my job. So, I turned off the debt snowball and took the same money each month and funneled it to the emergency fund. Just about done with that and plan to pick up on the debt snowball where I left off.
If you are in a single income household and worried at all about your job, do the emergency fund first. The peace and security this brings is worth more than you can imagine. If you are secure in your job and/or are in a dual income household, do the debt payoff first.
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I like this approach. My wife and I initially put $1,000 into our emergency fund and haven’t dipped into it yet, but has sure given us a piece of mind. It makes it pretty easy to cut up your credit cards if you have $1,000 chilling in the bank.
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Before you start the e-fund, you really need to define for yourself what is and what is not an ‘emergency.’ In my case, I define an emergency as job loss, health issues resulting in inability to work, legal duress, natural disaster or civic disruption requiring relocation. Based upon this narrow definition, I was able to determine how much money I would need and where to store it (part of it stored for immediate access and part stored for chronic or long-term conditions).
More to the question, I built up an emergency fund using my tax refund (an instant chunk of cash) prior to tackling the debt. Then, when the debt had been reduced to striking distance of total elimination, I sacrificed the emergency fund to kill the debt. Then I started rebuilding the emergency fund, once again using my tax refund as a starting point to having a longer term emergency fund that is capable of sustaining my basic needs for 6 months and growing.
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@ James, #26; welcome to the USA. Here, your body is just like a car; if you want to take good care of it, you have to spend a lot of $$$. And if you’re poor & you bust it up, too bad.
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Like many have already said, I think it depends on the person. The biggest factor in deciding which to do first is the security of your job. If your job is reasonably secure for the next year, then a minimal EF makes sense. If, however, you can’t be sure that your job is totally secure (or worse yet) you know layoffs are coming at your firm), then a maximum EF is necessary.
Personally, I am two years into my job now and feel that it is secure for at least the next year. Therefore, I am now taking my 3 month emergency fund and paying off a student loan. I’ll spend the next year building the EF back up. I can re-assess at that time how secure my job seems. If it still seems secure I will likely use that money to pay off my HELOC (my last debt outside my mortgage!) and then replenish my EF for the last time.
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Great post. I enjoyed reading it.
I think a mix between the two is best. You never know what life throws at you, so an emergency fund should top the priority list for anyone, yet debt could be hurtful in the long term.
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Pulled from the book review referenced at the top of this post:
“You can’t have financial harmony without emotional intimacy, she says.”
I wonder what that author thinks about the relationships between, say the CEO and CFO at major companies?
Anyway…
It’s hard for me to answer this question, since I’m not working on either of these goals, but I think that if I had debts to pay off and no savings, I’d start by saving a small cushion, maybe $500-$1000, and then I’d aggressively start tackling the debt.
$500-1000 covers most day to day unforeseen expenses, and in the case of some sort of catastrophic financial event (job loss or something), then it’s not going to matter whether you started with one or the other since presumably this is happening within a fairly short timeframe following the starting point of no savings and lots of debt.
At this point though, I think it’d be worth starting to talk about how an ounce of prevention is worth a pound of cure. We wouldn’t need so many discussions about debt snowballs and such if we could preemptively change our behavior and that of those around us by discouraging them from taking on debt in the first place.
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When figuring out where to put my money in terms of building up the emergency fund or paying off credit card debt, I first figured out what expenses I would have in an emergency, i.e. a job loss. Most of my expenses could be paid with a credit card, except for rent and a few other expenses. As a result, I first established an emergency fund with cash reserves equal to a couple of months of rent, and then proceeded to pay off my credit cards. I figured that in an emergency I could always start using my credit cards to pay expenses. At the same time, I knew that by paying off the credit card I was getting a return on my money over 13% and that my savings account got closer to 2%. Therefore, I would rather get the 13%, build up my available credit in case of emergency, and wait to build up a cash reserve until my high interest credit card debt is paid off. This only applied to high interest loans. I am waiting to pay off my car, mostly because I have an ultra low interest rate.
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I think it also depends on the type of debt in addition to the person.
For us, if we had high interest credit card debt we wouldn’t have an emergency fund (maybe a small one depending on the size of the debt). Our credit card would be our emergency fund. But with low interest student loan debt, the emergency fund is more important (and sometimes higher interest) than paying off the student loan debt. Same with mortgage debt.
We’re very high-interest debt averse, so there wouldn’t be that temptation to use the credit card for unnecessary expenses if it had a balance. But someone who has difficulties with that, the Dave Ramsey approach is definitely the way to go.
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To me, building an emergency fund before paying your debt is the same thing as using credit to pay for emergencies, because while you’re putting the money into savings, you’re racking up interest on your existing debt. Therefore, by the time you use that emergency account to pay for an emergency, it has cost you in interest already.
In contrast, using credit for an emergency only costs you interest when there actually IS an emergency. Building an emergency fund first will cost you interest whether there is an emergency or not.
It doesn’t sound safer or smarter to me. I’d say the only possible benefit to that approach would be entirely psychological.
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I think Ramsey’s approach is accurate, since he’s al about behavior modification rather than sheer numbers. The first step is of course ceasing to acquire any more debt. A $1K emergency fund keeps you from resorting to credit cards whenever something unexpected happens, so that’s gotta be first.
I think Kevin #15 has it wrong in this regard: if you’re living paycheck to paycheck, the first thing you need to do is to build a sense of safety and break your dependence on credit for emergencies. Then you can pay off your debts without raising them again the next time you get a tooth ache.
For people like me, self-employed and with an irregular income, it makes sense to build a greater cushion (3-6 months) before starting to pay off the vultures. I need a stocked pantry and utilities and health care money before anybody else sees a penny from me. I’m useless when hungry, sick or dead.
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If you have enough debt that it’s going to take years to pay off, even using the snowball method, it seems foolish to assume that you will never have an emergency during that time period; a car problem, dental emergency, broken pipe, etc.
One way or another you’ll have to pay for that, whether you’ve diverted money ahead of time to the emergency fund, or go further into debt instead, by using a credit card. It’s more of an emotional decision; what will hurt more, taking money away from debt repayment to build the EF, or having to put that car repair on the credit card you’ve been working so hard to pay off?
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I’m with Nicole (#34). We have student loan debt and a mid-sized emergency fund. Currently we’re beefing up the emergency fund.
Rationale: Employment situation is not stable. If we didn’t have an emergency fund, and do lose jobs (decently high chance) we’d have to use high-interest debt to fund daily expenses. You can’t eat paid-off student loans! We do have the “extra” emergency fund savings that we have saved during this uncertain period earmarked, and when have have some sign of stability, we’ll make a big dump to the loans.
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I can’t imagine anyone choosing to have less than $1000 in their emergency fund. If things are really tight for you, this may be a difficult sum to aim for, but if you can build that minimal amount, you really should.
If you’re surviving on a single salary, and/or if you are reliant on your job or substantial private payments to cover your health costs, and/or you don’t have a rock-solid guarantee of continued work, and/or you have other people depending on you, you need an emergency fund. If you can manage 3-6 months of bare bones expenses, that’s even better. You can’t rely on credit cards for true emergency expenses: you may not be able to pay mortgage or rent with a card (and will have to take out a cash advance at an exorbitant rate), and, as mentioned above, you may find your credit limit cut at the pleasure of the card issuer.
I’m a Canadian freelancer with a mortgage, so I need an emergency fund, even though health care is, thank goodness, not a huge worry. I still have a 4 figure credit card debt that I’m paying down at $100 a month, which is more than the minimum but which is still pretty slow. But my credit card company has usually offered me a very low interest rate for several months at a time — typically between 2% and 5% — and when it didn’t, I could move the debt to a bank line of credit at about 4%. While doing this, I’ve put away an emergency fund that is now slightly larger than my credit balance.
I would LOVE to pay off that balance, but I need a few more months of solid work to take that step. My latest credit card interest rate is 0% until May, so any extra money will go to my tax free savings account (maximum $5000 each calendar year). In May, depending on how I stand, I will be in a position to pay off all or part of the credit card debt in one swell foop, assuming that work is still steady.
If you have a high credit card interest rate, then you may have to choose a minimal emergency fund. But I can’t see anyone justifying no emergency fund at all.
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Reading everyone’s stories of house and car-related emergencies makes me sort of happy I don’t have to worry about either. Of course I always could get sick and have big med bills not covered fully by insurance, so it’s not like i can dodge all types of emergencies, but not having a house or a car lowers the risk a lot.
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Thanks for this post. I’ve been sitting working on finances all morning and this led me to play with my debt calculator again since my small emergency fund I started with has been depleted. Well, I did my math and basically it comes down to this– building an emergency fund of $1000 right now would cost me about $500. But, because I have been at this for some time now I’m at the point where I have room in my budget to absorb small things. So I’ve actually decided to switch gears with my debt repayment and go avalance. I’ve been snowballing and it’s been working well but I’m at the point where the two of my three remaining largest balances are the two highest rates and they’re just destroying me. Thanks for the prompt to re-examine though. Much appreciated!
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I definitely like the way you did it; $1,000 then an aggressive debt snowball. I felt like I was in a catch-22 deciding on which to focus on first. I’m also thinking about splitting my 20%: 10% to savings and 10% (additional) to my debt.
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Kevin @ 15:
“Something that always confuses me is, when pundits say you should have 3-6 months of expenses in emergency savings, what are they counting as “expenses?””
They are counting the things you are paying to others, not the things you are paying yourself (E-Fund, debt snowball, retirement).
You could even take it one step further. If you had a true emergency, what other costs would you cut? Frex, in a financial emergency, we’d cut our cable tv, and we’d go vegetarian. We’d likely also be spending less on transportation (depending on the type of emergency this may or may not be possible). Our e-fund covers 6 months at that level of external expenses and no income coming in at all.
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While I totally “get” the difference between 1% in a SA and 22% or more on a CC, I think the point for the individual should be whether or not they want to reframe how they’re going to use credit cards OR eliminate them from their life. For me it was about eliminating them, so I needed to have the savings cushion as soon as possible. I just am not capable of being responsible with one. I’m responsible with my money, just not credit. Weird, I know, but true. But I think if you can handle the temptation and use them just for the rewards or to track regular expenses, etc., then you might lighten up on the emergency fund contributions while you pay down the debt.
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We kind of worked out a hybrid system. We started with a $1000 padding in the bank for small emergencies. Then we split our efforts half and half between a larger, separate emergency fund and our credit cards.
Once we got to the amount we wanted for our larger emergency fund, we switched all of our contributions to the credit cards. I don’t know if this makes sense interest-wise, but it worked for our psyches.
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For the same reason that you recommend a hybrid approach to the emergency fund vs. debt snowball, I also recommend a hybrid approach to the debt paydown method.
Dave Ramsey writes about paying off each small debt so that you can gain a psychological advantage by seeing your debt disappear. While I can agree to some of the logic here, it ignores the varying interest rates if you have more than one card with a balance.
So the hybrid method is to pay off the smallest card first … this gives you a boost to see a debt balance disappear … but then, move immediately to paying off the card with the highest interest rate. In the long run, this will be much more effective and save more in interest.
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Sierra says:
“When an unusual expense crops up, I can dip into my debt snowball to cover it. I’ve never had to touch our emergency fund yet.”
The key is that you had enough cash flow that one month to handle the ENTIRE expense without taking on new debt. You have to understand that this makes you a relatively well off debtor.
This debate only makes a difference for people who have so little income that it takes months to save enough cash to cover one emergency.
If all you had left at the end of the month was $50, you would be stupid to put it towards debt right away. You’d be forced to take out new debt to cover the next emergency. However if you can save that $50 for a few months, it will hopefully be enough to see you through an unexpected expense without creating new debt. Once you get to the point where you have a comfortable cushion, you start diverting your extra cash towards debt repayment.
You have to break the cycle of continuously creating NEW debt before you can dig out of the old debt, and that absolutely requires an emergency fund. Credit card vs. savings account interest rates are irrelevant until you get to that point.
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@JC #48- Ramsey doesn’t ignore the varying interest rates, he makes a point of discussing them when he presents his method. However, he chooses to emphasize behavior over arithmetic, because people who get in trouble with debt usually don’t have a problem with doing math, they have a problem with their behavior.
At some point of course one may decide they have changed their behavior enough that they can prioritize high-interest over the snowball approach, and how many debt payments does that take depends on the person– one, two, five, sixteen– everybody is different and has different debt loads.
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