I may get a lot of flak for saying this but I think having an emergency fund while you’re in debt is a terrible idea.
Most frugal bloggers (and debt reduction plans) stress the importance of saving for an emergency fund while also paying down debt.
Once you’re out of debt, it’s easy to fall back in with just one (even minor) event. A pet gets hit by a car and incurs a hefty vet bill; a kid’s growing a little faster than you had planned for; or maybe you have to miss some work and you’re out of sick days.
If you don’t have an emergency fund (EF) in place, you’ll end up financing the costs on the credit card…. And then you’re back in the debt loop.
This sounds logical; but is an EF really such a good deal?
Let’s say you find out you need $300. If you have an EF fund, you simply take the money out and start building up again. And you probably think that’s better than charging the $300, which increases your debt.
But, in fact, an EF really won’t make a big difference.
A way around the whole problem
The best way to avoid this pitfall in the first place is to make a payment each payday. Tim and I have done this for months now and it’s much easier. The longer money sits in your account, waiting to be paid out, the less you’ll inevitably have. A couple small grocery trips, a pizza out with friends and suddenly that extra $100 payment you wanted to make has vanished into the ether.
Additionally, paying your creditors every time you get paid means less chance of late fees and also more flexibility with unexpected expenses. You can simply make a smaller payment for a given month, while using the rest to cover that pricey surprise.
Going this route also means that your money isn’t sitting in an account somewhere earning little to no interest, while your credit card balance continues to earn plenty.
Getting back to EFs
But there are times when even this plan doesn’t pan out — often because the unexpected cost times itself to happen right after all your payments have cleared. In which case, you’re right back to the emergency-fund or no-emergency-fund question.
Let’s assume that you have a credit card with 12% APR, which is 1% a month. You make payments of $400 against your balance, which is currently $5000. Meanwhile, you’ve been throwing $100 a month into your emergency fund.
So, for those with an emergency fund, your balance wouldn’t change. But, because you were using $50 a paycheck to grow your EF, you’re making just the $400 payments.
On the other hand, if you threw all your money at debt, things are a little different: Your balance increases by $300, and your payments are $100 more a month.
So you see, by Month 3, the balances are only $6.08 apart. And the interest paid is only $6.07 cents less for those with an emergency fund. That’s a grand total of $12.15 for the trouble of always being sure to pay yourself first and not get the relief of having every possible cent thrown at your debt.
Of course, for some, building an EF is psychologically soothing: You have a safety net. And a lot of debt reduction is about finding what works for you — whether or not it makes sense to anyone else. So long as your debt goes down, it really doesn’t matter what others think.
That makes sense when you’re talking about $12.15. But, as time goes on, the disparity gets much more pronounced.
With an EF
|Month 4||Month 5||Month 6|
Without an EF
|Month 4||Month 5||Month 6|
Starting in Month 4, the non-EF balance is $93.86 lower. That’s almost twice what you’re putting away in your fund each month!
By Month 5, the difference in balances has more than doubled: $194.80. And by Month 6, the difference is $296.74.
In fact, with my method, you pay off the credit card debt two months earlier (Month 12 instead of Month 14) — even if you have another $300 “surprise” somewhere in that time period.
And let’s not forget that, even if you put your EF into a “high-yield” account, you’re still looking at no more than probably 6% in this economy. Even assuming your card’s rate were actually 12% (and they’re double that — or more), that’s still a losing proposition.
Caution: Not one size fits all
But I would like to take a moment to point out I’m not issuing an edict. This might not work for certain people. Looking at the numbers, we can make a couple of generalizations:
Throwing all your money at debt is better for you if:
- The amounts you pay on debt are far enough over and above the minimum due that you can make smaller payments in the case of unexpected expenses.
- You pay with each paycheck to give yourself added flexibility in dealing with “surprise” costs.
- You don’t get these “surprises” more than two or three times a year.
Having an emergency fund is better for you if
- You have major unexpected expenses occur four or more times a year.
- These expenses would mean a significant charge on your cards (if the EF weren’t available)
- You are unable to pay for “surprises” out of pocket and still make the required minimum payments on your debt.
Regardless of which route you take, you should be wary of too many unexpected expenses in your life. While, of course, you have to account for sheer dumb luck (or lack thereof), generally speaking if there are a lot of financial surprises in your life, that may say more about your budget than the unpredictability of this crazy ole’ world.
In other words: You may want to sit down and take another look at your allotment of funds. Are you accounting for everything?
Most of us don’t. I often forget gradual things, like wearing out shoes. I can’t ever quite account for Tim’s doctor co-pays for any given time span, because there will be two weeks without any visits, followed by a MRSA outbreak or eczema flare-up that necessitates anywhere from 2 to 6 appointments. Each with its own $15 co-pay. It just means I had to learn how to be flexible.
So tell me: Do you still think an EF is a good idea? Why?
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