Yesterday, I discussed a post over on Enemy of Debt that I didn’t completely agree with. But that’s not the end of the disagreement. (I should add that Brad and I chat amicably most of the time. He’s a totally good guy; he just has the bad taste to not have my exact views. Silly man!)
Brad and I got off on the tangent of emergency funds. He was concerned that we don’t have any savings in case of emergency. I explained my point of view: Emergency funds may not be the best use of your money.
That’s how a long, long discussion began in his otherwise normal comments section.
Once a week, I leave a certain amount in the bank. The rest of the funds are put against our credit card debt.
Pretty simplistic, I know; but it works for us. If an expense pops out of the woodwork, we try to cover it with our weekly funds. If that isn’t possible, we put it on the card. One to two weeks later, it’s paid off.
After our credit card debt is paid off, I will make an emergency fund one of my top priorities. Until then, though, it just doesn’t make good financial sense for us to put away money that could go toward debt. My disability checks will always cover rent. If Tim and I both found ourselves out of work, we have the option of applying for food stamps until we could get back into the working world.
Brad accepted that perhaps it was a tenable system for smaller amounts. He asked what would happen if we couldn’t pay the whole amount off in a single month. Then, we’d be back to earning interest on the card.
First of all, the expense would have to be pretty significant. About $2,000, to be exact. Since we pay between $1,500 and $1,800 a month, we could get rid of any lingering balances pretty quickly. Of course, sometimes big, expensive emergencies crop up.
So my other answer would be this: We’re still better off.
Let’s say we have to charge $2,500 or so onto the cards. We couldn’t pay that back in under a month. So it would remain on the card and accrue some interest.
Even so, we’re still paying less in the long run. If you’ve kept $3,000 back from debt reduction, that’s $3,000 that is accruing interest all of the months it sits there. So even a couple of months’ interest is less than the interest you paid when you decided not to apply your emergency funds to your debt.
The trouble with EFs
In a way, you’re paying a premium for the privilege of an emergency fund. Let’s assume an average APR of 10-15 percent on a credit card. Banks are offering perhaps 1-2 percent. That means you’re paying around 8-13 percent in interest on that money in the bank.
In addition, EFs manage to take money away twice. First, you put the money into an account, rather than using it to pay down debt. Later, as you use the money in the account, you have to put more in to replenish your fund.
That’s twice that you have to divert money from a productive, current need into a “what if” account.
So what’s it to you?
Obviously, I’m not in the majority here — either in opinion or financial situation. Still, I think it’s safe to say that not everyone benefits from getting an emergency fund.
My main contention with the whole concept is that there are some logical fallacies inherent in them.
Dave Ramsey tells you to save up just $1,000 then get on with debt reduction. In a pinch, this would pay your rent for one to two months, max. In that way it’s useful, but I think most of us associate “emergency fund” with some huge, unexpected bill.
If the emergency is more than $1,000, it sort of seems like the whole process was kind of pointless. A $2,000 car repair bill will mean you’re still adding to your card’s balance. You can charge a smaller amount, but the results are about the same. You’ll pay off the $1,000 you charged, and you’ll need to replenish the EF with another $1,000.
How is that so different from charging the whole $2,000 and paying it off with your next couple of checks? Either way, you’re paying $2,000. Of course, if you have an emergency fund you do get to let $1,000 sit around, essentially gathering dust, while your credit card debt gathers interest.
The more traditional suggestion is to have 3-6 months’ expenses in the bank. That’s a goal to shoot for even while you’re still paying down your debt.
On the face of it, at least this concept makes a little more sense. You save enough so that you could pay a few months’ expenses in case of lost income. It seems like there’s more point to that than the arbitrary $1,000. Once again, though, there’s the problem of how to best use your money.
If you could live on $1,000 a month, then you would need a minimum of $3,000 in the bank. Meanwhile, the alleged average credit card debt is around $10,000. So your emergency fund would be about a third of your overall debt burden.
Following the plan’s rules, then, you have enough to pay off almost a third of your debt; but instead you don’t touch it. You’re told you might need it later.
But don’t you also need it now?
Suze Orman’s new suggestion is to build up your savings at any cost. Keep up with minimum monthly payments, but otherwise funnel your money into savings.
It’s a credit card company’s dream come true: You’re making timely payments, and the company is making interest revenue hand over fist. I hope it’s clear that I find this whole idea to be pretty problematic.
Back to the drawing board
Please don’t get me wrong: Depending on your situation, you may need to follow one of the philosophies that I disagree with. I’m completely okay with that.
Finance is as much about psychology as it is about math. While I find comfort in not letting funds sit around idly, others need to know there’s a safety net, just in case. Whatever lets you sleep at night.
I’m well aware that you can’t really dictate what works for everyone. That’s usually my point when I talk about stuff like this: There are exceptions to the rule — more often than you might think.
Which is why it’s amusing to watch people’s reactions. Inevitably, someone will argue with me, implying that my method is imprudent or financially harmful. I then explain the math and/or logic behind my system. The argument ends after that. Yet, almost inevitably, the person tells me that personal finance is personal. So what works for me might not work for everyone else.
Getting back on point, I just want people to realize it’s okay to ask questions. Even when it’s one of the most basic rules of personal finance, it may not be for you.
Our individual situations are, well… individual. You need to figure out what systems work best for your purposes and goals. Choose what makes the most sense for you, what best meets your needs and priorities.
Whatever you do, just ask yourself this from time to time: Am I doing this because it’s right for me? Or because other people told me it was right?
What’s your take on emergency funds? Do you ever have to alter (or discard) basic tenets of personal finance?