If You’re In Debt, Why Have A Cash Emergency Fund?
There are a number of different viewpoints on what an emergency fund is and what constitutes an emergency fund. While a cash emergency fund may be seen by many as the ideal, there are also arguments for emergency funds that consist of various lines of credit - from home equity to overdrafts to credit cards, and others I haven’t listed here.
An argument I hear quite often (and that makes sound mathematical sense) is that if you are in debt, having a cash emergency fund is costing you money, because typically you are earning less interest in your emergency fund than you are paying out to your debt. This is certainly mathematically true for me - my lowest interest debt is currently at 4% (with another at 7% and the last at 9%) while my ING Direct savings account earns somewhere in the neighborhood of 3% interest. Maybe a little higher or lower, I haven’t checked lately.
But from my perspective, this is again a place where personal finance is about both the personal and the finance. Adding additional debt, for me, would be very psychologically taxing. I personally don’t need the reward boost that the Ramsey plan gives from paying off debt in the order of small balances to large, but I do need that boost of watching my overall number go down, as well as the specific types of debt go down as well. This has come into focus a number of times for me over our debt reduction journey - most recenly with two large unplanned expenses. The first, a major car repair, caught me short and I had to finance $800 of the $3600 bill. Although I did not pay any interest on the financing and I paid it off within a month, it literally drove me mad increasing our overall debt, even for that short amount of time. I can’t imagine if we’d had to finance all $3600. I might still be upset. That experience caused me to make a few changes in how we accumulate our debt payoff money as well as our emergency fund, building in a lag time to help temporarily increase our emergency fund every month while still focusing on our debt reduction. So when the latest $3700 expense, the new furnace, occurred, we were better able to handle it without incurring more debt. And I can tell you, that gave me a lot of peace of mind.
So why have a cash emergency fund while you’re in debt? It depends on your personal in the realm of personal finance. Be honest with yourself - what would be the psychological ramifications for you of having to increase your debtload if (when) an emergency happened? If your answer is that it would completely throw you off track, a cash emergency fund may be the right compromise for you. If it wouldn’t cause you to miss a beat in your debt reduction focus, than a credit-based emergency fund may work in your favor. Whatever you decide, being true to who you are and not what works for someone else is the key to navigating this tricky road of debt reduction.
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May 12th, 2008 at 7:35 am
Not only is an emergency fund (while you’re in debt) good for the peace of mind, it can prevent people from absolute financial disaster.
Say a person decided to get out of debt, but all lines of credit were maxed out. Then, you get a nail in your tire and need a new one. That $100-150 to get a new one could seem like a million bucks, if you absolutely don’t have the money.
It’s good to have some money set aside, so emergencies don’t become full-blown disasters.
May 12th, 2008 at 9:42 am
Unless you’re so strapped that it’s all you can do to pay down the debt and eat, you really should be contributing part of each paycheck toward an emergency fund. Surprise expenses happen, whether you’re in debt or not.
You’ll never get ahead if every time you turn around you have to rack up MORE debt to keep the car running, the plumbing operative, and the cat alive. And as you point out, even when you’re faced with a really big bill that exceeds your savings, an emergency fund can help limit the amount you have to finance.
May 12th, 2008 at 3:15 pm
For me the idea of the emergency fund is to get into the mindset of savings. Right now I can only afford to put $10 a month into my fund..but I started off putting in only $3. I found ways to cut more and more and since I was already in the habit of saving the gradual move up to $10 monthly was not difficult.
I think most people do not realize that you can build your fund and pay off debt at the same time. I am doing it and although my fund now stands at a little over $100 (I had to cash it out one time to take care of something) it still feels good to know that if the sky fell I had $100 I could easily get my hands on.
May 12th, 2008 at 3:50 pm
I am with lulugal as I can only contribute $10.00 a month to my ING savings account. But, hopefully, I will increase it as my contract work increases.
May 12th, 2008 at 4:45 pm
I agree that the emergency fund helps me psychologically. It’s great to know that I won’t increase my debt due to an emergency. However, I have been toying with draining my emergency fund when I’m down to my final month paying off my credit cards. Right now, I’m sending the equivalent of my baby emergency fund to my cards each month. So, I think I’ll knock the end of the debt off one month early with the EF and then replenish it the next month. After that, I’ll be saving up a real emergency fund. Hooray!
May 12th, 2008 at 5:45 pm
I understand the emotion behind the emergency fund. As long as I can tap my equity line, I don’t mind having little to no cash at the ready. The HELOC is currently 3.75% (2.5% after tax).
As long as you know you’re paying 6% (the difference from the 9% card to the 3% you earn) for the comfort of the emergency account, that’s a decision that works for you.
Joe
May 13th, 2008 at 9:05 am
People:
If you have a revolving line of credit and you use excess cash to fund a savings account, you are, in effect, borrowing (at a higher interest rate) to fund a savings account earning interest at a lower interest rate. Example: You owe $100 on a HELOC at 5% and you contribute $100 to your savings account at 3%. After one year, you will have a net loss of $2. This is, per se, irrational. Now some may say, “but JMG, if I don’t have $100 in my savings account, I’ll have to borrow to pay for that $100 emergency.” True, but so what! The emergency may never come, but if it does, then borrow the money at that time. If you are adverse to debt, why borrow money to pay for an emergency before the emergency arrives??? If you elect not to pay off your HELOC, you’re borrowing BEFORE the emergency. From a pure dollars and sense perspective, you are better off borrowing if and when the emergency comes, rather than in anticipation of an emergency that may never come.
People: it is irrational thinking about money that gets people into trouble in the first place (e.g., I know I don’t have the money, but I deserve a new iPod). It’s hard for me to understand how more irrational thinking is the cure for past irrational thinking.
May 13th, 2008 at 9:23 am
After two “emergencies” in less than 5 months totaling together a little over $7000, I have to respectfully disagree, and that is the point of my post. Being another $7000 in debt right now (and for me, it would be credit cards, I don’t have a HELOC) would be soul-crushing.
I contend that it isn’t necessarily irrational thinking about money that get people in trouble in the first place as much as for some it is just *not* thinking about money. Prescribing that there is a one-size-fits-all answer is how “people” stay in debt.
May 13th, 2008 at 9:25 am
Oh and besides - “losing” a little (and yes, its a little) money in interest vs debt repayment to stay with the way that is working great for me - is way cheaper than a debt consolidation program or a money management class.