Taking the first few steps to ensure your future financial stability can be daunting. There is so much to do, trying to decide where to start can result in wasted time, and wasted time is wasted money. Eliminating debt is often the first priority, and rightly so. If debt is in the form of credit cards, interest payments could be a massive drag on finances. Credit card companies love offering low minimum payments because they know that consumers who pay only the minimum, and continue adding more debt, will be customers for life. How else could the system get away with taking $20,000 from a customer who purchased a computer worth $1,500?
If you are spending less than you earn, you have the capacity to divert your excess income to long-term savings, debt payments, and an emergency fund. You probably have a desire to put all of you excess income towards reducing that debt, and that’s understandable. Mathematically, that makes the most sense. Credit card interest could accrue at an annual rate of 9.9%, 14.9%, 29.9%, or even worse. It’s highly unlikely that your money can earn that much in any other safe investment over the long term, so paying off debt gives you the most bang for your buck. It’s simple math.
Simple math doesn’t always have the answer when it comes to your money. No, I am not advocating taking emotions into account. Doing what “feels right” isn’t the best option here. But the point is that there are more mathematics to weigh than just interest rates, and it’s the type of math that you can’t plug into online debt payment calculators.
I’ll explain. By diverting all of your excess money to debt repayment without beefing up your savings, you are taking a risk. You are betting that nothing will cause you to incur more debt during the payoff process. Even though your money in a savings account will not earn as much as the amount you’ll save by paying off debt, you have to take into account “known unknowns” and “unknown unknowns.” As the chief financial officer (CFO) of your own life, you have to manage that risj in addition to counting dollars and cents in the bank.
People in corporations get paid lots of money to perform risk management, and if the current financial crisis teaches us anything, it’s that risk managers don’t always do their job perfectly. It is difficult when dealing with issues facing large corporations and industry leaders, but for most people who deal only with loans, credit card debt, future expenses, and investments, risk management can be boiled to its most basic form: have an emergency fund. How can this be applied to paying off debt? Is the emergency fund more important?
If you direct all your excess money to paying off debt, you are likely to fall back into debt the moment an emergency arises. If your water heater breaks and all your money has been directed to your credit cards, you will have to use a credit card again to pay for the repair. You’ve taken one step forward, but now you’re forced to take two, three or four steps backward.
My suggestion is to balance building an emergency fund with paying off debt. When you are ready to divert your excess income to improving your financial condition, start with defining two goals: pay off all of your debt without acquiring more and build a solid emergency fund, which depending on the economy and the market for your skills, might consist of three months’, six months’ or one year’s worth of expenses. Don’t know your monthly expenses? Track where your money is going first.
Start by funding a base for your emergency fund. Pay the minimum to your credit cards or other debt, don’t accrue new debt, and send any extra money to a high-yield savings account until you’ve built one month’s worth of expenses. This will allow you to mitigate some risk while paying down your debt.
Once you’ve reached a one-month buffer, start sending extra money to your credit card with the highest interest rate. I suggest allocating 75% of your excess funds to this first targeted credit card (using the Debt Avalanche method) and 25% to your emergency fund. Keep sending money to your emergency fund month after month until your savings account cushion reaches the goal set above.
Once that target is reached, 100% of your surplus can be directed towards your highest interest rate card. You can rest easily with the knowledge that even while you’ve dramatically reduced the money you throw away to interest payments, you’re financially protected against a temporary loss of income or the typical emergencies you might face. This is just my opinion; maybe you have some thoughts that might be better. Doing anything is better than doing nothing. Do what works for you, if you’ve educated yourself.
Got questions? I (Flexo) and Ramit from I Will Teach You to be Rich are teaming up to answer all of your questions about money. Ask us questions today!
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{ 14 comments… read them below or add one }
Is the main advantage to this method the psychological boost people get by having an emergency fund? On a purely financial basis, it seems best to pay off debt exclusively before building up a fund — $100 to go to pay off debt at a 10 percent rate is far better than $100 earning a percent or two of interest, even if you end up drawing from the credit card a few months later to pay off an unexpected bill.
Erin: No, it’s not about the psychological boost at all. It is about risk management. Paying off debt exclusively opens you up to a significant vulnerability of going back into debt at the first minor emergency that forces you to spend in one month more than you earn. A small buffer in your emergency fund (one month’s expenses) will help you mitigate that risk while beginning your debt payoff, and continuing to use part of your money to *fully* fund your emergency account will make sure you are well-equipped to handle the next emergency *without* going into debt.
I should also point out that an “unexpected bill” can be one of the tamest emergencies someone might face. Loss of a job, particularly in this economy, should be just about everyone’s concern no matter how secure you believe you are.
I’ve been plugging away at paying off my credit cards. Paid off $54K in 7 months. 12K left to go….and that 12K has been lingering for about 8 months because I have been having to save a TON of money (enough to pay off that 12K) for a huge cross country move. I have zero emergency fund. Our monthly income is our emergency fund. If we pay the minimum on the credit card (which is at a 0% promo rate for another 2 months) and have no money going into the moving fund (which will be fully funded in 4 days) we typically have about 3 months of living expenses left over. I know it’s not the best way to do things, but it works for us. Now we have to start saving up the 10-20K that we’re going to lose on our house (that’s if it ever sells).
I think that you should pay of debt first as long as you have access to that debt in an emergency, like a credit card or a line of credit.
If it’s debt that you could not re-use then I agree with Flexo, make sure you have some emergency capacity.
Excellent points. Getting out of debt will take most of us anywhere from months to years to accomplish, and during that time there will be financial surprises.
While working on our debt, we have chosen to put more money into savings than some approaches might advocate. When unexpected home repairs and dental work came up last year, we had money available to pay those bills.
On one hand we are getting out of debt slower, but on the other hand we are not incurring any new debt, which is an important “line in the sand” at this point. Now I know to call it “risk management”, which sounds cooler and makes me feel smarter!
As far as paying off debt vs. building an emergency fund, I think it depends on what the debt is and what the interest rate is on the debt. We have been working hard on paying off debt and only very recently felt like it made sense to start an emergency fund. If you have high interest debt, or a lot of debt, it does not make sense to put money in savings and get virtually no interest for it these days.
I think you would find that it does make sense if you experience a financial emergency while paying off your debt. I think I tried to communicate in the article that pure numbers don’t tell the whole story when you’re measuring risk. Yes, it’s more “expensive” to put some money in an emergency fund than to use the full amount of money available to pay off debt, but you’ll find it will be significantly more “expensive” if you’re faced with an emergency without an emergency fund.
Everyone has to evaluate their own personal situation to decide what to do, but it would be a mistake not to take risk into account.
Can you give us an example or something to show us how it would be “significantly more ‘expensive’ if you’re faced with an emergency without an emergency fund”? If it’s just that you go back deeper into debt, then you’re no worse off than you were in the other scenario, and are probably slightly better off (in that you saved more money in interest on debt than you would have earned in interest on savings). There has to be something else at work here, e.g. you can’t access the credit any more, or the combination of job loss + credit usage gets flagged under universal default and increases all your interest rates, or something else. Simply referring to the risk of an emergency when you have no emergency fund doesn’t prove the point.
Far enough, I’ll put some examples together tonight to illustrate the point.
Another reason to build an emergency fund first is the credit cards can always lower your rates on you, even potentially below your current balance: http://consumerist.com/5170484/your-credit-card-limit-can-be-reduced-below-your-current-balance .
-MBirchmeier
I put together an excel spreadsheet to demonstrate this principle, but need a place to upload it. I’ve got 4 scenarios modeled
2 years of all money paying down debt
2 years of half of the money paying down debt, half towards savings
2 years of all money paying down debt with a large unexpected bill half way through adding to the debt
2 years of half of the money paying down debt, half towards savings with a large unexpected bill half way through that wipes out all savings (the large bills in both scenarios were the same amount).
I’m assuming a debt interest rate of 10% APY compounded monthly, a savings rate of 2% APY compounded monthly, a $5000 initial debt, and $100 total to go towards either savings or debt each month.
If you pay $100 towards debt each month, after 24 months you are down to $3416 with no savings, with a net worth of – $3416.
If you pay $50 towards debt each month, and $50 towards savings, you are left with $1202 in savings and 4700 in debt, with a net worth of – $3531.
What happens if, in month 14, you receive a $700 bill that you werent expecting?
In scenario 1, it’s added to the debt burden, which you continue to pay off at $100 per month.
In scenario 2, it is exactly equal to the amount saved thus far, leaving you with only your remaining debt.
In scenario 1, you had got down to $4113 in debt, but now we add in that $700 putting you almost back where you started! Since you have no savings, you’re at a -$4814 net worth.
In scenario 2, you’ve managed to save $700 (which is now wiped out) but you’re debt is still pretty high at a remaining balance of $4850, so your net wealth is -$4850.
You are in fact slightly better off continuing to pay down the debt, despite the large bill.
I have the excel sheet I used to calculate this out if anyone would like to see it.
Ben: Thanks for providing the spreadsheet. I’ll upload the sheet tonight for anyone who is interested.
I hadn’t noticed the post that followed this one. While it doesn’t work out to save some while pay off debt from any numerical point of view, “sleeping better” might make it worth while for some people.