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?