Start An Emergency Fund Or Pay Off Debt?
By Pinyo • Jul 25th, 2008 • Category: Credit and DebtNot long ago, I participated in a lively conversation in the GRS forums entitled: Debt Snowball vs. Emergency Fund. The premise is very simple. Should the person start an emergency fund while he’s still in debt? In this case, we are talking specifically about credit card debt averaging 15% in interest.
Photo by redjar via Flickr
In this article, we will follow this sample scenario: A man (we’ll call him Jerry) owes $5,000 in credit card debt at 15% interest rate. The monthly minimum payment on his credit cards is $100 per month. Jerry could pay $200 per month maximum.
Start An Emergency Fund
If you are a Dave Ramsey fan, the answer is simple: “Start a $1,000 emergency fund then pay off debt using the Debt Snowball”. This way, you don’t have to rely on your credit cards in case of an emergency. If we follow the scenario above, Jerry would:
- Take 10 months to build the $1,000 emergency fund.
- During those 10 months, he would have paid $1,000 toward his credit cards. Of which, $603.19 went to interest payment and $396.81 went to the principal — leaving him with a $4,603.19 remaining balance.
- From there, it would take him another 28 months to get rid of his credit card debt, and it would cost him another $859.01 in interest.
All in all, it took Jerry 38 months and $1,462.20 in interest payment to get rid of the $5,000 debt and build $1,000 emergency fund.
Pay Off Debt
While I think Dave Ramsey’s plan is fine, I wouldn’t do it his way if I were in that situation. Personally, I want to use everything in my arsenal to pay down my debt as fast as I could. If we follow the scenario above, Jerry would:
- Take 31 months to get rid of debt.
- In that time, Jerry would have paid $1,032.66 in interest.
- After the debt is paid off, it would take him another 5 months to build a $1,000 emergency fund.
All in all, it took Jerry 36 months and $1,032.20 in interest payment to get rid of the $5,000 debt and build $1,000 emergency fund. The difference is approximately $400, or almost 10% of $5,000!
Note: You could try out the various scenarios using the Bankrate credit card payment calculator.
Okay, some of you may ask what would I do if I run into an emergency while I don’t have an emergency fund. The answer is quite simple. I would use my credit cards as my emergency fund.
What would you do if you were in this situation?
I’ve been in this situation before and decided to build an emergency fund before paying down debts. When emergencies happen, and they will, and you turn back to credit cards you are simply spinning your wheels.
For us, it worked out well to fund an emergency fund of about $3k to catch small to medium emergencies, keep one credit card open for catastrophic emergencies, and pay off everything else.
I do agree that the math looks appealing for paying off the debt first, but sometimes you have to pay a little for peace of mind.
Your scenario fails to take into account that Jerry might have an emergency. Would Jerry then need to grab his credit card to pay for it? What would the financial effect of THAT be? Yikes.
Putting the emergency expenses on the credit card is not the issue. It is the fact that it is there tempting you to use it for non-emergencies. Your definition of an emergency might change if you have $1,000 in the bank or a $5,000 credit limit.
How about rolling the $5000 debt to a zero percent interest card (special balance offer) for 6 months. Build the emergency fund in those 6 months, pay down the debt at the same time and save yourself 6 months worth of interest.
Works even better if you can get a zero percent card at 12 months.
I would build the emergency fund. To me, the risk presented by the high probability of an emergency occurring within the next three years isn’t worth the potential $400 savings. Plus, if you are keeping the emergency fund in a high-yield savings account, that potential $400 difference is even less.
I agree with the other commenters - I know for me personally, once I hit my credit card with that $1000 car repair, then it was REAL tempting to go out to dinner that night - cuz what’s another $80 on a $1000 day? And it’s a mood buster - you think you’re doing well paying down the debt and then it’s right back up again.
Actually, Dave Ramsey would tell Jerry to sell some stuff/take on a second job/trim the budget to nothing, get that mini emergency fund in place for the inevitable, and quit screwing around. Two and a half to three years to get rid of $5k isn’t anything like focus, and coming at your debt like that is a sure way of keeping it around forever.
I tend to support your (Pinyo) point of view, but primarily because of the speed with which you could pay off this particular debt. I would think this would work especially well if you have an unused, low interest back up CC for the “emergencies”. You could acquire one prior to beginning the aggressive payoff.
The problem with most is the addiction to using plastic for non emergencies, and thus the theory one must go cold turkey when aspiring to become debt free.
I think also you have to define “emergency”. The only true emergency I can think of is something of catastrophic proportion, something you couldn’t have predicted, something $1000 wouldn’t have covered anyway; so I guess I’m thinking Ramsey’s $1K “emergency fund” is really an illusion anyway. If you were to incur a $1K “emergency”, couldn’t put it off (e.g., not repairing car until done with debt) and put it on a CC, it’d be pretty easy to wipe out quickly,in this scenario, and would be a sobering reminder to create a maintenance/medical deductible/premiums/whatever fund once out of debt.
Larger credit card debt is a different problem, when you are looking at YEARS of paying down debt, then creating and maintaining a fund early on for life’s predictable glitches becomes more imperative, as you’re actually embarking on a lifestyle which will, sadly, chronically include debt repayment.
You say you’d use your credit card for your emergency. So what’s the point of paying off the debt if it’ll go right back up when you use it for your emergency? You’re not breaking the cycle. How would you have saved $400 if you had increased your debt by using your credit card for your emergency(ies)?
We tried doing things the way your recommend (we have a lot more debt though) but “emergencies” kept cropping up. We got a little drastic and coughed up a $1,000 emergency fund and haven’t used our credit cards for over a year. The emergency fund is still in tact and we’re making good progress on the debt. It’s amazing what qualifies as an emergency when your fund is plastic and what qualifies (or rather doesn’t) when you have to pull that hard won cash out of the bank to cover it. All of the sudden, my husband is a lot handier around the house and I’m a lot more creative at problem solving and making do until we find the cash to replace or fix something. However, if we only had $5,000 in debt, we’d probably save up a smaller cash cushion ($250-$300) and work the debt. The cushion wouldn’t help a lot, but since we haven’t touched the bigger emergency fund, it might provide the psychological aspect and keep us from using the card for an emergency that really could wait.
I agree with Sean. And not just because his name is Sean. Try and change as many of the variables as possible.
I agree an emergency fund is critical. I am in the process of setting up a CD ladder to serve as my emergency fund. Setting up six 6-months CD’s, one that matures every month…I am halfway there, hopefully I can reach my goal
Thank you. I enjoy the various perspectives shared here. Let me just throw in two points:
1. Dave Ramsey’s argument assumes that people will continue to be irresponsible with credit cards and that’s why they need to be put away for good. If the person is determined to get out of debt and use his credit cards responsibly, I don’t see why my method wouldn’t work.
2. Let’s say you follow DR’s method and there’s an emergency, would you: (A) rebuild the emergency fund and further delay debt repayment, or (B) continue with the Debt Snowball full force?
If you can handle using credit cards for emergency use only, then the second way is better. I think DR’s method is for people who need to make a change in the way they handle their finances. At this point, the goal is to retire the debt once and for all. If that takes a little more time and money, but guarantees the debt is retired, then that is what it takes.
Although I agree with the overall result as you have clearly described above, I promote contributing to the “emergency fund” even with just a few dollars. The primary reason is that once people who are in debt complete the payoff, they don’t know what to do next!! I have seen this numerous times.
By getting in the habit of contributing to the emergency fund over a greater period of time, the person will have something they can contribute to once the debts are paid off.
I think the key ingredient with the emergency fund vs. debt snowball is the stabilizing force that the emergency fund is.
For those who are trying to get back on track financially the emergency fund is a place of stability for them. You are a lot less rocked by the storms of life.
The numbers run and work but the variable is always emotion with humans. Security is an emotion and the emergency fund is security. It allows persons working to get out of debt to take a breath before they begin to tackle the debt snowball.
I also agree with the idea that usually when you are starting to pay off debt there needs to be other adjustments in your life. Most likely the reason the person used the credit card before was for emergencies. That is a mindset change that needs to happen. They must go from thinking, “I will just put it on the credit card, weather the storm and pay it off later.”
Emotion is the key variable.