Emergency Fund Versus Getting Out of Debt?
Mon, May 24, 2010
People have certainly changed their motivation of getting out debt and saving based on experiences from this past recession. Many Americans were cash poor and paid dearly because of it. This was evident after so many people were laid off and had no cash to cover expenses while they searched for new employment. Many unfortunate people also lost their homes to foreclosure because of too much leverage with no cushion for protection. Given these circumstances people wonder today if they should pay off debt with savings, or save more cash (instead of paying off debt) in case of another economic crisis or job lay off. So, what’s the right answer to these questions?
Build an emergency fund versus getting out of debt?
If you look at The Crown Money Map or Dave Ramsey’s Baby Steps you’ll find both suggest saving $100o before paying off debt. This is suggested to help you avoid the use of a credit cards should an unforeseen emergency related expense arise. However, The Money Map, differing from the Baby Steps, suggests you save one month’s living expenses after paying off credit cards to further establish safety. The Baby Steps suggest paying off all debt before saving more money. Obviously, the Money Map is in favor of more initial cash savings.
Believe me, I’m all for taking Dave Ramsey’s approach of using gazelle like intensity in paying off debt. I hate debt. But, I also don’t think it’s wise to spend too much time paying off debt with only $1000 in the bank. Of course, Dave suggests you should be motivated to getting out of debt and making sacrifices to do so in a short amount of time. I agree, but many people may pay down debt slowly with only this $1o00 in savings for a couple of years. Having only $1000 in savings is unwise unless you can approach your debt pay reduction with the intensity he talks about.
So, emergency savings or paying off debt? The answer, is both. You should save the initial $1000, pay off your credit card debt and then grow your cash savings to one month’s living expenses. Once you’ve attained that savings goal, continue your debt pay off plan with Dave’s gazelle-like intensity.
Use your emergency fund to get out of debt?
But, perhaps you’re unlike many people today and already have several months in emergency savings, but are still carrying some amount of debt around with you. Should you use some of your emergency savings to pay off your debt?
The previous answer helps answer this question too. In this particular situation, I go back to keeping the one month’s emergency savings on-hand. For example if you have 3 month’s of expenses saved and are still in debt (other than the mortgage), I suggest paying off the debt and leave 1 month’s living expenses in your emergency savings account. You can then build your emergency savings back up when you’re out of debt.
The bottom line is you are still furthering your journey to financial freedom if you pause debt pay off to get to save one month’s living expenses. One you start your debt pay off plan again, you’ll be much more financially secure and the chances of you going back into debt for surprise expenses will be much less. But, make sure you’re using intensity, motivation and dedication in saving the one month’s living expenses, otherwise, it will drag on too long while your debt limits your freedom and costs you more money.
What do you think about an emergency fund versus getting out of debt?
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Tags: Crown Money Map, Dave Ramsey, Debt, Emergency Savings
Like you, I also believe that $1,000 is MUCH too low for an emergency fund. I would suggest at least $2,500 to $3,000. One can shift all “extra” money to the emergency fund and then once it hit’s $1,000 begin to split the shift between your EF and accelerated debt repayment. Once you hit your EF goal, shift all money to debt. Then afterwards, build your EF to about 9 months up to a year of living expenses.
Khaleef @ KNS Financial´s last blog ..What Does the New Testament Teach About Tithing?
Khaleef, interesting thought. I like allocating 100% of extra money to build the emergency fund to one month and then focus the rest on debt, but I suppose it all depends on your risk tolerance. Thanks for the comment!
Jason´s last blog ..Emergency Fund Versus Getting Out of Debt?
An emergency fund is essential especially if you are carrying a debt load. A good emergency fund can get you out of trouble if you are faced with say, car repairs or a leaky roof when credit is no loner available. A minimum of one months salary is a must, 3 months is better, and 6 months is optimum. Paying down your debt should remain a priority but having an emergency fund will help you to avoid future debt.
Suzanne
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@ Jason,
My wife and I reevaluated our plans and decided to do exactly what you suggested. We will plow 100% of all extra money to our EF until we hit one month of expenses. Then we will attack our debt!
Khaleef @ KNS Financial´s last blog ..Trying to Reduce Expenses? Sweat the Big Stuff! – Car Costs
Khaleef, have you paid off any credit card related debt? I would also consider how quickly you can build the 1 month’s living expense. If it’s going to take you years you may choose to still work on some debt. But, as I mentioned in the article, I like the idea of having 1 month’s living expenses set aside as quickly as possible.