Not 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?
Pinyo is the owner of Moolanomy Personal Finance and a Realtor® licensed in Virginia and Maryland. Over the past 20 years, Pinyo has enjoyed a diverse career as an investor, entrepreneur, business executive, educator, financial literacy author, and Realtor®.