Saturday, March 14

Emergency fund vs debt -- the eternal debate

Free From Broke recently wrote a piece about extending one’s emergency fund. Instead of the normal 3-6 months’ worth of expenses, FFB suggested it might be reasonable – given the current uncertain economy – to pad the account up to 8-12 months’ living costs.

I understand the fear of uncertainty. We read, day in and day out, about mass layoffs, imperiled companies, and other, generally foreboding news. With that as a backdrop, it’s no wonder that people would look for extra reassurance. After all, there’s no guarantee that a laid-off worker would be able to find a job in 6 months’ time.

But I wonder: At what point do our current problems outweigh future uncertainty?

For me and Tim, it doesn’t make financial sense to have an emergency fund. We don’t have a car, so no unexpected repairs. Our rent is covered by my disability check. And in the unlikely, simultaneous event that my contract work was canceled and Tim’s unemployment benefits ran out, we would cut back to the bare essentials and apply for food stamps. So it makes more sense to us to throw everything we have at debt.

For others, though, the answer is not so clear. For example, you can’t predict with certainty whether you will qualify for unemployment. Even if you do, that may not cover your mortgage. So having some funds in abeyance would be a good idea.

That said, we come back to the age-old (for me anyway) argument: How much should you save for potential future needs if you have definite current ones?

Your debts are probably accruing at least 7 percent interest. Your emergency fund, by contrast, will be earning 2 percent or less. At what point does that “lost money” begin to matter? Because that’s exactly what it is: It’s money you’re losing out on to secure a perceived future need.

I’m not saying it’s wrong. Certainly, if your unemployment isn’t enough to cover your expenses – especially something like a mortgage – then you need to have a safety net. But each money choice we make carries an opportunity cost.

If you keep money in checking rather than savings, your opportunity cost is the interest you’re losing out on. If you put your money in a CD, your opportunity cost is anything you could have done with the money, if it weren’t locked away. Likewise, if you build up your emergency fund, your opportunity cost is all the extra interest you pay over the course of your debt reduction.

So how many months’ worth of expenses are you willing to save up at the cost of a longer debt-repayment plan?

Of course, the old pro-EF argument goes: The money doesn’t have to come out in big chunks. You can pay up your EF slowly, while still paying down your debt.

Still, the numbers have to be considered: Paying down less debt – even if it’s to build up an EF – means more interest. Eventually, that has to be a factor in your decision.

And that decision will vary, depending on the people making it. For some, peace of mind outweighs the math. They would rather pay a little bit extra in interest and get a nice large cushion “just in case.” And they’d want to build up that cushion quickly. Depending on interest rates, this could hamper their ability to pay down debt quickly. But for them, a good night’s sleep (aka no more 3 a.m. “what if” panic attacks) is going to be worth more than anything. For others, debt that exists now is worth a whole lot more than any problems that might be in the future. They may choose to put off saving an emergency fund at all – at least until their debt is gone.

Most people, I think, will fall somewhere in between these two extremes. They’ll divert some money away from debt payments. But not enough to be remarkable. It will mean that they may or may not reach their 8-12 month goal before a layoff happens. But they’ll know they’re working toward securing themselves for the future, which is enough for them.

I think there’s one more factor to take into account: What kind of debt is it?

I’ve tried to be pretty open about my absolute, knee-jerk reaction to debt. Debt=bad. End of discussion. I’m working on it. So imagine my surprise when I read an argument for paying down less debt and it made sense to me!

This was from one of my favorite PF writer’s Liz Pulliam Weston. She suggests that the kind of debt should have a lot to do with your priorities – at least in times of uncertainty. If you make extra payments on student loans, then are unexpectedly fired, that money is a distant memory. You can’t get it back, short of going back to school and getting more loans. If, on the other hand, you funnel extra money toward credit card debt and get fired, you at least have your credit line as your absolute last, use-only-in-desperation safety net.

So, what does all this mean?

I have no idea. Seriously. Like I said, Tim and I are weirdly fortunate to be close to the bottom rung. We don’t have far to fall. And we are incredibly lucky to have very supportive parents who will always help out however they can.

But all that means – for the purposes of this post, anyway – is that I really have no clue what a realistic emergency fund would look like. Sure, I know about how much our expenses are, but we don’t own a home or a car. We don’t have kids. And we have, relative to our area, a pretty low income. So I don’t know how much most people spend on funding their EFs.

So I guess I’ll put it to you: How much of an emergency fund do you need to feel safe? Has that number increased in recent months? How much do/did you put toward your EF each month? How much would have to be in the bank for 8-12 months’ expenses? For you, is that a better investment than paying down debt? Do you have a point where one supersedes the other?

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Blogger Shevy said...

Ideas like this (putting 8 to 12 months in an EF) just about put me over the edge! I would need to have $24,000 or $50,000 in my EF to live on for a year, depending on whether we up and moved to our rural home or stayed here in the city.

I put away $12/week in my ING EF account. If I never had another emergency in the interim it would take me about 38 and a half YEARS to save up the smaller of those 2 amounts. At which time I'll be, um, about 90 years old.

Actually, I have enough to keep us going for a year. The only problem is it's tied up in Eldest Daughter's house and refinancing is a tad difficult at the present time.

My goal is to have $1,000 in my EF. But it goes up and down. Right now I have $151.47 in my EF, so I have a way to go.

Okay, now I'm depressed enough that I might actually write a pity party comment....

March 14, 2009 at 9:13 PM

Blogger Shtinkykat said...

Looks like a lot of us are on the same wavelength of asking ourselves, how much EF do I need? The struggle between saving vs. paying off debt gnaws at me on a daily basis. Both are of equal priority and importance to me. I've resigned myself that life is a constant compromise and I need to attack my goals on multiple-fronts simultaneously. Some may criticize me for diluting my efforts but the act of saving gives me great joy and comfort. You're right that there are no simple right answers. My ultimate goal is to have a year's worth of EF. But this is a looooong-term goal and I celebrate interim milestones along the way.

March 15, 2009 at 7:14 AM

Blogger Funny about Money said...

Augh! Obviously, you can't be stashing money in an emergency fund if you're struggling to make ends meet. Seems to me if you're in financial trouble or close to it, your best bet is probably to try to pay down revolving debt (which wouldn't include student loans or a mortgage). If anything's left, bully: put it in savings, even if it is just 12 bucks a month. Hey...two months' worth will buy you a bag of groceries, eh?

I think you're right that a low-interest note, such as a student loan, should be way down on the list of priorities. The mortgage could be seen as the equivalent of rent, just one of those things you have to pay to keep a roof over your head. Dunno about car payments...I was able to pay off a 5-year car loan in 18 months by applying an extra $80 or $100 a month, but I had a good deal on the loan from a credit union. Could be that if push came to shove, you'd have to sell a car that you still owed on, if you could get enough to cover the loan.

I've always thought you should stash a year or 18 months' worth of living expenses. If you're in middle or upper management, the rule of thumb is that finding a new job takes a month for every year of experience you least it was, before the Bush economy collapsed. Who knows how long it would take when there are no jobs,to speak of?

Over here, I'm compromising: took an extra job to pay the $23,000 I owe on a second mortgage,but instead of paying off the note I'm keeping the cash in savings until the risk of layoff passes.

March 15, 2009 at 7:28 AM

Blogger Meg said...

Ideally, I'd like to have 8-12 months because I think it would take at least that long for my husband to find a comparable job based on our experience with his field. In fact, he's kept his eye out for another job for much longer without any luck. Even if he got unemployment (and didn't have to wait months to get it like some people), it just wouldn't cover our expenses because of the debt.

Right now, though, we've let our EF fall from about 4 months to 2 months so we could get a handle on our debt as interest rates have been increasing. Fortunately, we are pretty confident in him keeping his job for at least a year and even if he didn't, we have family that has said that they would help us out (and we actually trust them).

Still, we want to grow our EF back up and then some while continuing to pay down our debt. So, it's tough deciding how much of each we do -- and sometimes the choice is probably based much more on emotions than logic. But at least by paying down the debt we are also decreasing the amount of money that we need to save since debt payments are currently our biggest expense.

March 15, 2009 at 9:01 AM

Blogger Meg said...

I agree w/ Shevy. I read that you should have 6 months living expenses before you try freelancing, which almost made my head explode. Fortunately, we were in a position where the choice was between freelancing or being unemployed, so that made it easier.

I don't have a steady income so I don't save a reliable amount. I try to put a bit into savings from each invoice but there always seems to be something much more pressing to pay off first. We never get ahead on school loans, but at least we are not accumulating any more debt. Treading water, I guess.

Some of our precarious financial situation is a direct result of our choices. (We also had some really bad luck) Stick and I basically choose to be freaking broke all the time in order to both pursue interesting jobs. I hope in the future, we'll be stable financially AND we won't have Sunday night misery / Monday morning anxiety. Then we'll look back on our years with no disposable income and laugh! (At least, that's how it happens in my head)

March 15, 2009 at 9:14 AM

Blogger Mrs. Modern Tightwad said...

I'm glad you wrote this because I've been thinking about it for a while now. We are very fortunate IMHO to have one month's income in an emergency fund which is approx. 1.5 months of bare bones expenses. But with 47,000 in debt I worry more about being in debt for the rest of my life than I do about my EF right now, which I know is a mental thing.

I've actually been thinking about decreasing our emergency fund to pay off debt, as our monthly expenses go down every time I pay off a debt (therefore the ef need goes down as well). Currently, I think I'm going to try the method where you add your snowflake to the emergency fund until you have enough to cover the entire bill so that I'll either have a larger ef or be able to knock out an entire payment.

I think in your position you have a very healthy attitude about debt because you have a solid emergency plan that only works if you don't have debt. So in truth, you're just being smart. :)

March 15, 2009 at 9:50 AM

Blogger Free From Broke said...

This is a great question! When I wrote my post I didn't really take into effect a person with lots of credit card debt. If you have CC debt then paying that off will instantly add to your bottom line in that you will no longer have interest building up on top of your original debt. Other debt like mortgage and student loans (except some private loans) can wait until after you have an emergency fund.

But still, it depends on each person's situation. The point of my article was that unemployment is way up and you can't expect to get a job as quickly as you could a few years ago (in most industries). Imagine you're in banking - How long would it take to find a new job with all the competition of everyone else laid off? Not sure 3 months is realistic. But every person's situation is different.

Thanks for raising the question, I think it's something I need to explore myself.

March 15, 2009 at 6:29 PM

Blogger Abby said...


Eesh, I'm sorry that your money is tied up in real estate, right now.

And with kids in the house, I have no doubt that your expenses would be that high for a year! Still, at least you're trying to get an EF started, which shows that you're working on it. I think that's all most of us can shoot for these days.


I think you're right in celebrating the small milestones along the way. And so what if you're not an all-or-nothing gal? I think diversifying is probably one of the smarter things to do. Generally, I like to go full force on one subject, but that has more to do with my knee-jerk fear of debt than any rational thought process. Do what makes you most comfortable. You're the one who has to live with the consequences, after all!

Funny About Money,

Whew, that's an impressive amount to have stashed away. But with the job market the way it is, I'm not sure I blame you for keeping it in the bank!

I would definitely love to have a one year EF some day. But I don't see that happening any time in the near future. I think it's just all about compromise, like most things in personal finance.

Meg (of Bargain Queens),

It's good to know that family has your back, isn't it? Certainly, my mom helps us out a lot. And I know that if push ever came to shove, Tim's parents would let us stay with them.

It sounds like your husband has a job that doesn't see a lot of turnover. So long as he's included in that trend, that's a good thing, I suppose. Still, I suppose that career field would be another factor in deciding about the size of one's EF.

It sounds like you're also trying to find a compromise between what kind of EF you'd like to have and what your current debt demands of things.

Meg (of Simpson's Paradox),

As I slowly declench when it comes to debt, I realize that now's the time in our lives when we SHOULD be taking risks. Okay, well... "now" referring more to age than actual economy. If we get into debt (by following our dreams) at this stage in our life, it doesn't derail plans nearly as much as it would in our late 30s to 40s. (Though I'm sure Tim and I will find a different way to derail them. We're talented like that.) So I'm glad you took a chance. Though it always helps when the other choice is bad, so we have a good excuse. I hope your freelance continues to grow!

Mrs. MT,

Thanks for the kudos. I think this subject is rather on everyone's mind at the moment.

As with most things in personal finance, it's a trade-off and often involves more compromise than we'd like.

Whether you should decrease your EF to pay down debt... Well, I guess it depends on your faith in the future/your and your husband's job security. If you have cause to think that your income is relatively stable, then it may make more sense to decrease the interest-bearing debt.

If you're not sure what the future holds, well then you're taking a bigger gamble. But it's more a psychological one. Consider:

If you owe $47,000 on credit cards and have a $3,000 EF, and then you need $2,000, you can access the EF and not put anything on the cards. Then you feel good at not having to resort to charging up your credit.

If you owe $47,000, have $3,000 in an EF and use it... Well, now you have $44,000. SO if an emergency occurs and you do have to put money on the card, you're still only up to $46,000. Which is still better (in my mind) than the other situation. (Assuming that you can make rent/mortgage or can put it on the credit card.)

Still, many people would feel defeated for having to charge up the card again. Even though the second method means, say, two months of having a lower debt earning interest.

So much of PF is psychology, unfortunately.


I hope you didn't take my article as an attack. I think of it more as an expansion of one angle of the equation.

If you have no debt (or mostly student loan/car debt) then I think it may make more sense to beef up your EF.

But for those of us with debt still, there is that constant question of whether you focus on just one, just the other, or dilute your efforts by both.

And I know for a fact I don't have an answer for this, because the situation I'm in is simply not the norm. (IE, we can cover our rent with my disability, so EF has been put on the back burner.) So I wanted to explore the question more and also get a feel for what everyone else thinks -- plus get an idea of what, exactly, 8-12 months EF would mean for most people.

I'll be interested to see any articles that you write exploring this issue further! (Any more tag-teaming and I may just have to make you a wrestling partner. Assuming our spouses wouldn't mind, of course!)

March 15, 2009 at 7:25 PM


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