Comments on: Which Comes First: Paying Off Debt or Starting Emergency Fund?

By: Ben

Ben — Tue, 17 Mar 2009 18:04:29 +0000

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.

By: Flexo

Flexo — Tue, 17 Mar 2009 17:49:30 +0000

Ben: Thanks for providing the spreadsheet. I’ll upload the sheet tonight for anyone who is interested.

By: Ben

Ben — Tue, 17 Mar 2009 16:38:54 +0000

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.

By: Flexo

Flexo — Mon, 16 Mar 2009 18:45:29 +0000

Far enough, I’ll put some examples together tonight to illustrate the point.

By: Steve

Steve — Mon, 16 Mar 2009 18:33:08 +0000

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.

By: MBirchmeier

MBirchmeier — Mon, 16 Mar 2009 18:14:34 +0000

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

By: Flexo

Flexo — Mon, 16 Mar 2009 15:52:01 +0000

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.

By: $ Money Savin' Momma $

$ Money Savin' Momma $ — Mon, 16 Mar 2009 15:36:38 +0000

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.

By: Bud

Bud — Mon, 16 Mar 2009 14:02:35 +0000

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!

By: Customers Revenge

Customers Revenge — Mon, 16 Mar 2009 13:40:15 +0000

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.

By: Twiggers

Twiggers — Mon, 16 Mar 2009 13:38:29 +0000

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).

By: Flexo

Flexo — Mon, 16 Mar 2009 13:26:08 +0000

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.

By: Flexo

Flexo — Mon, 16 Mar 2009 13:24:36 +0000

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.

By: Erin

Erin — Mon, 16 Mar 2009 12:37:14 +0000

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.