Emergency Fund vs. Debt Paydown
So lately, I’ve been listening to a lot of personal finance podcasts. Many of these podcasts revolve around people digging themselves out of the debt-hole they’ve sunk into.
Side not: It’s amazing to me how ill-prepared most people are to deal with money, and how cavalier our society is towards excessive spending and debt. But that’s another story for another day.
Anyway, one of the people I’ve been listening to is Dave Ramsey, and while I don’t always agree with his advice from a purely financial standpoint, I do think that it often makes sense from a behavioral standpoint. For example, his method of paying down debts, called the Debt-Snowball method, has people arrange their debts from lowest to highest balance and pay them off that way. Mathematically, this is not optimal, and you end up ahead if you arrange them from highest interest rate to lowest interest rate. Over the long term, you’ll pay your debts off faster and pay less in interest than you will using the debt snowball method. However, Dave recognizes this and advocates his method instead because of the psychological effect of paying off a larger number of small debts and maintaining a feeling of progress. This is just one example of how he tends to take behavioral issues into effect as well.
One of the things that has always annoyed me with most financial advisers is that they all tend to make statements like “First, you’ll need to make sure you have 3 to 6 months worth of savings as an emergency fund. Next, you’ll arrange your debts from highest to lowest interest rates and pay them off in that order.” Bam! Apparently, these people do not live in the real world and think that sound financial advice means telling people who are barely scraping by as it is to somehow save 6 months worth of expenses before they begin attacking their debts. Let’s take a look at how this strategy plays out in the real world.
If you make $30k per year, 6 months of expenses is $15,000. If you can afford to somehow set aside 20% of your after-tax income towards that emergency fund, and you never touch it (because you definitely won’t have any emergencies), it’ll take you nearly 4 years of saving up, assuming that your after-tax income is $2000 / month. 4 years. THEN you get to start paying down your debts. Are these people crazy? It’s doubtful that most of the people who are deeply in debt could put 5% aside for 4 years, let alone 20%. If you put 5% aside long enough to build up 6 months of reserves, it’ll take you almost 18 years! (not counting any interest earned on that money)
Here’s a better idea. Get $1000 together, and then start attacking your debts. If you have a true emergency, you have $1000, plus you always have the credit that you just paid off. I know that sounds crazy, but if you’re really serious about this, you’ll do almost anything to avoid going into more debt, while spending a few dollars of that $18,000 might look pretty tempting when your car breaks down or you get a speeding ticket. You have to cultivate the attitude that debt (except for mortgages, perhaps) is a cancer and almost anything (within your ethical and moral boundaries, of course) is better than incurring debt. If you do that, you can usually find some other way to deal with emergencies than spending on credit. However, if you have $18,000 sitting in your emergency fund, it’ll be pretty tempting to use a little of that to pay this and a little to pay that, and you don’t have that same drive to be creative.