Why I won't save an emergency fund
I may get a lot of flak for saying this but I think having an emergency fund while you're in debt is a terrible idea.
Most frugal bloggers (and debt reduction plans) stress the importance of saving for an emergency fund while also paying down debt.
The rationale
Once you're out of debt, it's easy to fall back in with just one (even minor) event. A pet gets hit by a car and incurs a hefty vet bill; a kid's growing a little faster than you had planned for; or maybe you have to miss some work and you're out of sick days.
If you don't have an emergency fund (EF) in place, you'll end up financing the costs on the credit card.... And then you're back in the debt loop.
This sounds logical; but is an EF really such a good deal?
Let's say you find out you need $300. If you have an EF fund, you simply take the money out and start building up again. And you probably think that's better than charging the $300, which increases your debt.
But, in fact, an EF really won't make a big difference.
A way around the whole problem
The best way to avoid this pitfall in the first place is to make a payment each payday. Tim and I have done this for months now and it's much easier. The longer money sits in your account, waiting to be paid out, the less you'll inevitably have. A couple small grocery trips, a pizza out with friends and suddenly that extra $100 payment you wanted to make has vanished into the ether.
Additionally, paying your creditors every time you get paid means less chance of late fees and also more flexibility with unexpected expenses. You can simply make a smaller payment for a given month, while using the rest to cover that pricey surprise.
Going this route also means that your money isn't sitting in an account somewhere earning little to no interest, while your credit card balance continues to earn plenty.
Getting back to EFs
But there are times when even this plan doesn't pan out -- often because the unexpected cost times itself to happen right after all your payments have cleared. In which case, you're right back to the emergency-fund or no-emergency-fund question.
Let's assume that you have a credit card with 12% APR, which is 1% a month. You make payments of $400 against your balance, which is currently $5000. Meanwhile, you've been throwing $100 a month into your emergency fund.
So, for those with an emergency fund, your balance wouldn't change. But, because you were using $50 a paycheck to grow your EF, you're making just the $400 payments.
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So you see, by Month 3, the balances are only $6.08 apart. And the interest paid is only $6.07 cents less for those with an emergency fund. That's a grand total of $12.15 for the trouble of always being sure to pay yourself first and not get the relief of having every possible cent thrown at your debt.
Of course, for some, building an EF is psychologically soothing: You have a safety net. And a lot of debt reduction is about finding what works for you -- whether or not it makes sense to anyone else. So long as your debt goes down, it really doesn't matter what others think.
That makes sense when you're talking about $12.15. But, as time goes on, the disparity gets much more pronounced.
With an EF
| Month 4 | Month 5 | Month 6 |
| 3939.47 | 3578.86 | 3214.65 |
| 400.00 | 400.00 | 400.00 |
| 39.39 | 35.79 | 32.15 |
| 3578.86 | 3214.65 | 2846.79 |
Without an EF
| Month 4 | Month 5 | Month 6 |
| 3945.55 | 3485.00 | 3019.85 |
| 500.00 | 500.00 | 500.00 |
| 39.46 | 34.85 | 30.20 |
| 3485.00 | 3019.85 | 2550.05 |
Starting in Month 4, the non-EF balance is $93.86 lower. That's almost twice what you're putting away in your fund each month!
By Month 5, the difference in balances has more than doubled: $194.80. And by Month 6, the difference is $296.74.
In fact, with my method, you pay off the credit card debt two months earlier (Month 12 instead of Month 14) -- even if you have another $300 "surprise" somewhere in that time period.
And let's not forget that, even if you put your EF into a "high-yield" account, you're still looking at no more than probably 6% in this economy. Even assuming your card's rate were actually 12% (and they're double that -- or more), that's still a losing proposition.
Caution: Not one size fits all
But I would like to take a moment to point out I'm not issuing an edict. This might not work for certain people. Looking at the numbers, we can make a couple of generalizations:
Throwing all your money at debt is better for you if:
- The amounts you pay on debt are far enough over and above the minimum due that you can make smaller payments in the case of unexpected expenses.
- You pay with each paycheck to give yourself added flexibility in dealing with "surprise" costs.
- You don't get these "surprises" more than two or three times a year.
Having an emergency fund is better for you if
- You have major unexpected expenses occur four or more times a year.
- These expenses would mean a significant charge on your cards (if the EF weren't available)
- You are unable to pay for "surprises" out of pocket and still make the required minimum payments on your debt.
That said...
Regardless of which route you take, you should be wary of too many unexpected expenses in your life. While, of course, you have to account for sheer dumb luck (or lack thereof), generally speaking if there are a lot of financial surprises in your life, that may say more about your budget than the unpredictability of this crazy ole' world.
In other words: You may want to sit down and take another look at your allotment of funds. Are you accounting for everything?
Most of us don't. I often forget gradual things, like wearing out shoes. I can't ever quite account for Tim's doctor co-pays for any given time span, because there will be two weeks without any visits, followed by a MRSA outbreak or eczema flare-up that necessitates anywhere from 2 to 6 appointments. Each with its own $15 co-pay. It just means I had to learn how to be flexible.
So tell me: Do you still think an EF is a good idea? Why?
Labels: credit card debt, debt reduction, emergency fund
posted by Abigail at
11:04 PM
31 Comments:
What do you do in case of a real emergency, though, like if you lose your income? Yes, we could put our emergency fund towards our debt, but if my husband lost his job we would be screwed as soon the bills came due. As is, though, we can survive for a few months at least.
August 12, 2008 at 11:38 PM
"A penny saved is a penny earned." - B. Franklin
August 13, 2008 at 8:38 AM
Meg,
This is a good question.
First, my husband is already out of work and I am on disability. We're still able to limit the amount we put on credit cards and pay our debt with his unemployment.
Second, you make it sound as though you'd put money on the cards eventually, anyway. You'd be able to survive for a few months. Then what? Increase your debt on cards?
If so, consider this: The amount that would allow you to survive "for a few months" would just be postponing you putting money on the cards. So while you aren't in trouble, you're paying interest rates on the debt you already have. The exact same rate you're trying to avoid in the future -- that emergency you're afraid of would force you to charge money to your card.
So you're cheating yourself now, just in case you need security later.
In other words, you can pay interest on CC debt now (before the emergency) or you can continue to pay interest on the debt now and again when your EF runs out.
I just think it's worth doing the math to see whether it's worth continuing to pay average CC interest rates for the months before an emergency. Say your husband loses his job in six months. How much interest will you have paid on that debt that could have been eradicated by applying your EF to it? I think you'll be surprised. It might be enough to start up another EF.
I'll be interested to hear any numbers you come up with.
Finally, I would like to point out that I'm not saying this is for everyone. This is what works for me. It might not work for you. I just want people to think their choices through, rather than blindly follow.
August 13, 2008 at 11:05 AM
When I say "survive", I mean cover our minimal living expenses including paying the minimums on all our debt payments so that we wouldn't incur extra late fees and higher interest rates -- or worse.
After a few months, I would hope that my husband and/or I would have found a suitable job. After which, we'd start building up the emergency fund again.
Right now we are doing a good job of lowering are debt. It's a slow process, but it's been going down steadily. And right now our interest rates are very low. At the moment, though, we're relying on my husband's salary which would take a while to fully replace if something happened to him or his job. Therefore, having an emergency fund is the best bet for us.
August 13, 2008 at 11:38 AM
Okay, well thanks for clarifying.
Again, I wasn't saying that this applies to everyone. In fact, I stated in the piece that a good chunk of debt reduction is about finding what works for you and going with it.
It sounds like you have sat down and figured out what works for you, personally. That is what I really care about.
August 13, 2008 at 11:58 AM
That's good to hear! It also sounds like you know what you're doing. I definitely agree that it's important for everyone to look carefully at their unique situations.
August 13, 2008 at 12:03 PM
Truthfully, I do think an emergency fund is important and that's because I once ended up losing my job and had no cash to get myself through. Sure, I could finance my bills through my line of credit or credit card but that is just awful. So although my debt load is very unpleasant, I still try to throw a little bit in the e-fund just in case.
Also, I think if you live in a situation where there are dual incomes the e-fund may make less sense. For me, I have no one else to rely on but myself.
August 14, 2008 at 9:01 PM
Well, obviously everyone has to do with what is right for herself (or himself but we're all gals here at present).
But especially if you are a good worker -- and thus will pretty much only lose your job in situations where you're eligible for unemployment -- I think my method makes more sense, financially.
That said, there are a ton of variables -- like how much you're putting aside in the EF.
And, as I say in the post, really in the end it's about what works for you not what is mathematically best or what the experts say.
August 14, 2008 at 9:41 PM
How does unemployment work where you are Abby? Like, how much can someone get and for how long?
Fortunately, we've never had to rely on it here. I tried looking up the info for my state, but -- and I could definitely be reading it wrong -- it sounds like at most it would only be the equivalent of about $275 a week tops. I sort of hope that's wrong.
August 14, 2008 at 10:55 PM
Unfortunately, we have had to rely on it. But we're hoping that with some advice from a vocational rehab center, Tim can figure out something he can do in and around his eczema. (Plus this way any employers would know about his issues in advance.)
Anyway, here in Washington, they take the last three quarters, drop the lowest paying one, average the two remaining and take 60% of that. You are then eligible for weekly increments of that money for a year. So in Tim's case that's $341 a week ($1364/month; $16368/yr). Which isn't actually that far off what he was making towards the end, because he was missing so much work.
It's certainly not ideal but it nicely postpones starving. Even when you have to pay $476 a month for insurance. (Tim can't get a cheaper individual plan thanks to the MRSA, so he is relying on keeping his insurance through work.)
August 14, 2008 at 11:06 PM
Wow, that sucks! I definitely hope things work out for you two. I don't know how we'd manage in that situation -- and I hope we never find out.
Unfortunately, even 60% just wouldn't cut it for us -- though we're definitely working hard to fix that. My husband and I are 'living' on a whole lot less than we used to, but long story short, we're still paying off a lot of debt we run up while in college. We're making slow but good progress, but it scares me how insecure our position really is due to the debt.
August 14, 2008 at 11:19 PM
Well, our expenses are relatively low. No car payments (we're about to have to start paying car insurance but it's on a 1991 Camry that his parents gave us as a wedding present). We live in an apartment. The rent keeps going up so we'll have to look elsewhere if it goes up much more, but for now we pay significantly less than a mortgage ($700).
I think those are the two places we save big time.
August 14, 2008 at 11:45 PM
That would help! We have a house and even though the mortgage is very reasonable, it's been a money pit. Sometimes apartment living sounds like a really good deal after all, especially since it gives you more flexibility when it comes to moving.
August 15, 2008 at 12:01 AM
It depends. Honestly I can see your point but if you are paying off debt for 5+ years I can guarantee you'll need cash to pay your mortgage during that time. $1k EF = 20% of my monthly expenses.
Not to mention medical insurance if we were unemployed. Sure it can all go on the card, but I'd have to take balance transfers or cash advances to pay the mortgage.
So I think it depends. If you can pay off debt in 12 months it's great. So don't use an EF. But if it's longer? Then things might be different.
August 15, 2008 at 4:28 PM
Well, I think the 5+ years thing is kind of missing the point. The EF is assuming problems, usually those don't last half a decade.
And I'm not saying you throw every cent against debt. Obviously, you have to keep money back for things like rent/mortgage and car payments.
What I'm saying is you shouldn't hold back money that could be going toward debt, just because you're afraid something might happen later. EFs only last for so long. Hopefully, you have enough to get a new job or recover from a bad burglary or whatever. But before that bad thing happens, the current debt you have is gaining interest at, what, 18%? So you can either pay down your debt now (and decrease interest paid) or you can keep money back while the debt grows and then months or years later you have the funds when you need it.
We're currently paying $476/month for Tim's COBRA insurance. We make sure that money is set aside before we pay the card. Same with rent which is $700, so less than the $1,000 you cited. But whatever we have left over goes to pay down debt.
That said, of course it depends, as you said. If your unemployment is completely untenable or if you think your employer will attempt to screw you out of unemployment, that can be a big factor in deciding about the EF.
Still, I generally assume that most of us PF bloggers are relatively industrious folks. So it's kind of unlikely that we'll get let go because of our work, but instead because of downsizing or company closing -- which qualifies you for unemployment. -- especially since once the EF runs out, you'll end up putting extra costs on your card.
For us, it just doesn't make sense to put off paying down debt because we're pretty much at the second-to-worst rung we can get. (The last rung being if Tim had to go on disability, too, which would mean $330/month in state aid for the 1-3 years it takes to get accepted by SSA.)
August 15, 2008 at 4:47 PM
Thankfully our rates are much lower than 18%, though I know people who pay more. We have excellent credit scores, though. Having an emergency fund means that we've never had late or missed payments on anything and wouldn't even if my husband lost his job tomorrow so long as we found another job with a similar salary within a few months (though that could still be very difficult).
August 15, 2008 at 6:03 PM
I think an emergency fund is more than simply "soothing" in the psychological sense. Most people with reasonable effort can save $1000 or so in an emergency fund within a month or two - a garage sale and an extra job delivering pizzas or newspapers would do the trick.
$1000 is enough to cover 90% of the financial "emergencies" that you might come across. Accomplishing this basic goal is likely to give you the confidence to tackle larger goals, like paying off debts.
$1000 isn't that much money, and it won't make a huge difference when applied to debt, but it does have a huge psychological impact if you've got cash in the bank and know you won't need to rely on your credit cards to finance an emergency.
I may disagree with some of the things Dave Ramsey advocates, but I think his first three "baby steps" are spot-on: save a small EF first ($1000), then pay off debts, then save a larger EF. Anybody who follows these three steps, in order, will find themselves in a massively-improved financial situation in short order.
August 17, 2008 at 8:59 AM
I believe that getting oneself out of debt should be the number one priority.
It does not make sense to me to be paying 12% interest on cc debt, while one's money sits earning 2% in savings.
It's just not logical.
So pay off your consumer debt and then start on an emergency fund.
-Katy Wolk-Stanley
"Use it up, wear it out, make it do or do without."
http://thenonconsumeradvocate,wordpress.com
August 17, 2008 at 11:03 AM
Thanks for commenting George.
But I am afraid I will have to disagree that $1000 isn't a lot of money. That's 10 percent of our debt. And I think that most people consider it quite a bit of money.
And do you really know people who have $1000 of stuff (at garage sale prices) sitting around? You and I know very different folks. garage sale stuff sitting around.
Also two months' worth of delivering newspapers or pizzas would be pretty unlikely to raise $1000. Minimum wage of around $8 times 20 hours a week, times four weeks. Take out taxes (even at just 15%) and extra gas money and convenience charges you'll rack up because you have less energy/time to be frugal with the second job... I'd wager you're looking at at least 4 months' work.
And would you really consider something that takes 1/3 a year "not that much money"?
Finally, you say that an EF is "more than 'psychologically soothing'" but you then say "it does have a huge psychological impact if you've got cash in the bank and know you won't need to rely on your credit cards to finance an emergency."
So, really, didn't you just confirm that a lot of an EF is about psychology?
Even so, that's not necessarily an criticism. As I say, psychology in debt reduction is important.
But, in the end, if you carry any kind of significant cc balance, you probably have a rate significantly over 12%.
Even 18% means $150/month in interest on $10,000. That's a lot of money to pay so that you can feel more secure knowing you don't have to increase your balance.
Thanks again for checking out my site.
August 17, 2008 at 11:17 AM
Amen, Consumer Advocate.
And thanks for reading!
August 17, 2008 at 11:18 AM
I really liked this post. I've been documenting my own struggle to pay off credit card debt and feeling like a loser for failing to maintain an EF. I had one going for a while. But, then we needed it for some extra bills. So, it was nice to have it there. But, being that I've switched my credit card balances over to 0% interest cards in an effort to pay down my debt more quickly, I feel better about not having that EF and just paying more money toward the creditors each month. Thanks for your perspective.
August 18, 2008 at 6:18 AM
It's sad that so much of whats written PF blogs is about getting out of debt not saving or investing. I guess the spenders out number the savers by a large margin
I've taken the balanced approach. We run our debt snowball and put any thing extra into savings. This allows us to save up money while still paying our debt off.
I personally prefer to focus on how much money we have in the bank than how much debt we have. Focusing on debt makes me feel like a failure, focusing on savings shows how much we've changed.
August 18, 2008 at 8:04 AM
Thanks for checking the site out, Ed!
I'm sorry you've been feeling like a loser. I definitely know how that can feel -- there are a lot of basic PF steps that I can't do given my situation... In the end you just have to sit down and figure out what is best (and feasible) for you. And I'm glad to hear maybe this post helped you a bit.
August 18, 2008 at 11:02 AM
Journeytofrugaldom,
I'm glad you found a good balance. And needing to focus on your accomplishments (saving) rather than ongoing sources of concern (debt) makes perfect sense. We all need some positive reinforcement from time to time. (Which is why Tim and I keep a running countdown of debt on our whiteboard. So we can see our progress.)
I say you're ahead of the game. You've found what works for you and that's great!
Personally, as soon as we have carved out a little breathing room, I'm more than happy to start saving.
I will be completely ecstatic to have a savings account again. Just right now it's not financially responsible -- or feasible.
August 18, 2008 at 11:53 AM
What the calculations here aren't quite taking into account is - what happens when you create more debt?
So the person who saved the $1000 first, they have that $1000 to put towards the emergency. The one who didn't, creates $1000 in debt and that debt has to be dealt with.
I used to think emergencies happened to other people. Then the engine in my car literally self-destructed without warning. $3600+ later, well, that wasn't fun. Then the $3000 new furnace a few months later...
without our $1000 emergency fund to help stop the bleeding each time, we'd have ended up in an even bigger hole.
People have to do what works for them. And the tone of this article at the start is more "emergency funds are stupid" than I can really roll with. The emergency fund serves more than a emotional purpose, it does serve a financial one too. Instead of just starting with more debt in your scenarios, throw in more debt midstream and see what happens.
August 18, 2008 at 11:21 PM
Well, I'm very sorry to hear that you thought I was so flippant.
I made a point of saying that this plan doesn't work for everyone -- even outlining details of who it will and won't work for. And I say that you have to do what's right for you.
Also, I did throw more debt in midstream. I specifically said that you would come out of debt two months earlier even if you had another $300 emergency.
I also make the point that you seem to be saying I missed: That EFs are psychologically important and in the end what works for you is what you should go with. ("Of course, for some, building an EF is psychologically soothing: You have a safety net. And a lot of debt reduction is about finding what works for you -- whether or not it makes sense to anyone else. So long as your debt goes down, it really doesn't matter what others think.")
One of my subsections even says "Caution, one size does not fit all" for crying out loud!
And you had a $3600 emergency. I know emergencies all too well, I'm afraid. Them, I understand.
What I don't get is how, under your logic, there's a (good) difference between putting the money in the bank to use in an emergency and putting it against debt to clear up credit limits for an emergency.
Look at it this way:
You start off with 10,000 debt. You slowly save $1000 EF and pay down, say, $3000. So when the car implodes you're at $7000 plus whatever interest you've earned in the meantime. So once you pay for the car, you're at $9600 (plus interest accrued up until now) because $1000 was from the EF and the other $2600 went on credit cards.
Now, assume you didn't have an EF but instead the money went directly to the card debt. So when the car implodes, you're at $6000 plus interest accrued -- which is arguably less interest, since your balance has been lower. At any rate, since you don't have an EF, the whole amount goes on the card. For a total of $9600.
Ignoring the issue of how much less interest is accrued on the debt, the outcome is exactly the same as if you had diligently saved in a bank.
August 18, 2008 at 11:58 PM
In your example, you listed putting money each month into the EF.
However, once the EF is funded, you would not put money each month into it. You would take any extra money towards your lowest debt.
So, what happens when window breaks? Pull money from the EF to repair it (no new debt) and then put any extra money (which had been going to lowest debt) into the EF. Once the EF fully funded again, start snowballing the extra money towards your lowest debt.
In addition, you may be able to 'save a few pennies' by paying CASH (Emergency Fund) for a service or repair instead of putting it on a CC (at 3%+ service fee to the provider/company) and then further incurring MORE interest on this new debt.
August 24, 2008 at 7:33 PM
You make some valid points here.
First, yes, some places will give you a cash discount, sometimes up to 5%. That is always a good approach. Also an angle I had forgotten about.
But I do want to put a caveat here once again that, if your money is accruing savings account interest and your debt is accruing credit card interest, generally you're still losing out. Even if you add in the extra discount for paying cash.
You also have a point that some people will stop adding to the EF once it's fully funded. But what, exactly, is fully funded? $1000 is one figure I've heard. But once your debt is further down, you're encouraged to beef it up.
And that's assuming no unhappy accidents that cause you to dip into the savings and then have to start funneling money again.
Finally your last argument, "...then further incurring MORE interest on this new debt." I've tried to explain this in the post and in numerous comments both here and on Get Rich Slowly (getrichslowly.org).
Most people who use this argument make it sound as though your credit card is going up to unprecedented new heights.
The fact is, the person not saving an EF is going to be farther down on his credit card balance. So putting the expense on the card doesn't mean that the non-EF person's balance will be suddenly so different from the person saving an EF.
That said, your comment made me realize I was assuming a starting point of zero. Because I was picturing two people just starting out on the debt repayment road.
So, if we assume that one person already has a partial-EF saved, the numbers do change a bit.
Abe has $1000 in an EF. He owes $5000 at 12%. An emergency comes up costing something under the amount in his EF. He dips in and then begins putting $100 back each month.
Brian has the same scenario, but no EF. He puts the cost on his card and pays that down an extra $100 per month.
The numbers do very slightly favor Abe. But that's assuming you're starting off with a fully-funded EF. And that the emergency isn't so big that the EF person ends up financing some on a credit card anyway.
Those are situations I don't even want to begin to try to calculate, lest my head explode in protest that it's the weekend.
Now, if Abe starts off with only, say, $800 in the bank when the $300 emergency hits, then it takes him until the end of the FIFTH month to get back: three months to pay off the emergency, two months to top off his EF.
By the fifth month, Brian's balance is $200 lower. Even with Abe paying an extra $100 when the EF is caught up, he still ends up with a bigger payment in the last month. On the other hand, he also ends up with $1000 in his EF, compared to Brian's $145.
Clearly, a lot depends on where these two people start from. I assumed a starting point of $0 in an EF. In which case, the difference came out well for Brian.
If you start the example when Abe's already been saving away, then the outcome is arguably quite different -- in favor of Abe & the EF.
Interesting food for thought.
August 24, 2008 at 9:27 PM
What will you do when your credit card company slashes your credit limit? It's happening to people nationwide. Then your ccs as an emergency fund plan doesn't work.
August 25, 2008 at 12:41 PM
This is an interesting point. When you commented, I did a search for the trend you were referencing.
http://abclocal.go.com/kabc/story?section=news/consumer&id=5664133
http://www.thisismoney.co.uk/credit-and-loans/article.html?in_article_id=430712&in_page_id=9
The first article says this occurs generally if you open new lines of credit, pay late or other drop in credit score. The second article focuses on the UK and said it may have something to do with those who aren't using much of their credit.
So, while technically we should be safe from either scenario, these are trends to watch out for.
Here are a few reasons we're probably safe:
1. We pay online every week. This means that I see our credit limit online each week. I will thus notice a change.
2. Since we pay so frequently, we don't have late payments.
3. Since we pay so frequently, there's no drop in credit score.
That said, there is no real guarantee that this won't happen to us.
Currently, we have a ridiculous amount of credit. $6,000 on one card (33% of the limit is in use); $10,000 on another (about 90% in use); and a Citi card I've had for 12 years that has $10,000 on it. None of which is in use. That's probably the one most in danger of being slashed. But even so, we are slowly paying down the other two balances -- until student loans are paid off, around $50-100 per week -- so I don't think we have to worry about maxxing anything out.
We don't have a house or a car, which are about the only scenarios where we'd suddenly need thousands of dollars to cover expenses. In two months when we're finished with Tim's student loans, we will focus our attention on credit cards and probably pay down around $700-1000 a month.
So I am not too terribly worried. But it is certainly a trend people should be aware of.
August 25, 2008 at 1:40 PM
I just posted on today's post about having one and that I finally do. I just know that for us it makes sense because we don't have life insurance, etc. and if my husband lost his job, we'd be out on the streets in one month. That's how tight it is. We need to have the emergency fund to cover expenses while we find new jobs.
September 19, 2008 at 4:32 PM
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