Tough choices: Pay down debt or save for emergencies?
Getting and staying debt free is full of tough choices. Should you stay in and eat alone (and save money) or eat out with friends (and go into debt)? Buy birthday gifts for your friends (go into debt) or explain why you can’t give gifts this year (and save money)?
No matter what decision you ultimately make, you’ve had to make a tough choice.
These are actually quite minor choices when compared to the choice I’m talking about today.
I’ve been struggling with the problem of how to decide what’s most important to me and my family: pay down debt or save for emergencies.
I realize how important it is to have a substantial emergency fund to tide you over when you’re trying to get out of debt. But I want to make the most financially beneficial decision I can make for my family, and one pat answer doesn’t seem to fit all situations.
Assuming you’re disciplined enough to follow through on any particular plan you make, you have options other than the standard idea of saving up $1,000 before you start paying off debt (Dave Ramsey’s famous “baby step 1”).
Assuming you have $1,000 of credit available for use in an emergency, and assuming your interest rates on the cards where you’re carrying a balance are on the high side, you can save plenty of interest by paying off debt before you start saving up an emergency fund.
However, that said, there are some things to take into consideration.
1. A cash emergency fund can be used in situations where credit might not.
Say you need to rush your dog to the veterinarian after he’s hit by a car. Your local vet is cheaper and closer, but he doesn’t take credit. A cash emergency fund might be the thing that gets your dog the care he needs for a price you won’t mind paying in the long term. This situation might be a stretch, but then again, I live in a rural area and I know several vets who don’t take credit cards and who need to be paid when services are rendered. The closest “big” city is an hour away.
The way I’ve found to get around this is to make use of the cash I have put aside for my budgeted irregular expenses. Although this cash is technically already assigned a task, in a pinch, it gives me cash reserves to tap into in the event of an emergency where only cash will do.
2. If you can’t repay the emergency expenditure quickly, your emergency will end up costing you interest, which you could have been paying toward your debt.
In simple terms, if you save up an emergency fund in an account that compounds daily at a 1% annual interest rate instead of paying on a debt that compounds daily at a reasonable 7% annual interest rate, you’ve lost 6% of your money to interest payments.
However, if you then have to charge something on a credit card because of a true emergency and it takes you 6 months to repay the money, your emergency has cost you 3.5% more than it would have if you’d paid cash.
Here’s what it looks like in dollars, roughly.
$1000 in the bank + $10 interest earned if you save a cash emergency fund
$1000 less debt + $70 interest saved if you pay debt first
$1000 debt + $35 interest paid if you have an emergency that would have used all your emergency funds and you’re able to repay within 6 months. If it takes you 12 months, you’ll pay $70 interest.
However, if you don’t have a card with a relatively low interest rate, there’s another possible downside. The interest paid on a card with a relatively high rate could be damagingly high.
You could get into a cycle of debt that takes many more months to pay off than you might ever have saved by paying debt before saving for emergencies.
If you pay late, you could be subject to high penalties, usually starting around $39, and your interest rate could jump even higher.
Net savings by choosing to pay off debt instead of saving for emergencies
Here’s a summary of the financial impact of one choice over the other.
Best case
The best case assumes you have no emergencies while you’re paying off your debt.
Pay off debt: Net worth up by $1,070
Save for emergencies: Net worth up by $1,010
Worst case
The worst case assumes you have an emergency that uses your entire “fund” and that you take 12 months to repay your emergency charge.
Pay off debt: Net worth down by $70
Save for emergencies: Net worth up by $10
Somewhere in the middle
Somewhere in the middle assumes you take 6 months to pay off your emergency charge.
Pay off debt: Net worth down by $35
Save for emergencies: Net worth up by $10
My decision
All that said, I made my decision not long after I’d decided to pay off my debt as quickly as possible. I chose to put as much of my discretionary funds toward paying off debt as soon as possible. My irregular expenses savings remains my only cash reserves at the moment, and although I rethink the issue every month or so, just to be sure nothing’s changed that might impact my decision, I believe I’ve made the right choice for me for the time being.
Truly, it’s somewhat of a gamble, but the payoff of getting out of debt sooner than I would have otherwise seems worth the risk to me.
Have you had to make a similar decision? What did you decide? Comments or questions are always welcome.
June 4th, 2009 at 12:09 am
I had to make the same decision. In July 2007 i was introduced to Dave Ramsey. At this time I hadn’t come up with a very solid financial plan, so I decided that I would apply the principles he teaches for one year to see how it would work out. So I have had a $1000 emergency fund for 2 years and I have paid about $45K towards debt (including interest). It has worked so far, so I am staying the course.
June 4th, 2009 at 8:35 am
We all have to do what works for us and keeps us motivated. By the way, I used your link to get me some free chocolate last Friday. :)
There might come a time when I decide it’s smarter to have that $1000 saved for emergencies, but for now, my savings for irregular expenses is working for me when I need quick cash, and I’m able to repay myself. Once I started budgeting for those irregular expenses, it’s amazing how many fewer emergencies I’ve had to deal with.
Also, I was very surprised by how much money I actually needed on hand to cover these quarterly and annual expenses. It was a shocker, for sure, but it’s amazing how much less stress one has to deal with when you know you’ll have your car insurance funds ready when your 6 month payment comes along.