Emergency funds VS debt free

I was reading one of those free advice columns, sort of like Ann Landers only on finance… The topic was being debt free vs having emergency funds. One guy wrote about how hard he’s working to get out of debt. Apparently, he and his wife have run up some significant debt—both on credit cards and in loans. They’d purchased a new car, new furniture for the house, and took a couple of great vacations.

At some point in time, they realized they were jeopardizing their future. They made a decision to become debt free. Their approach was to aggressively pay down the debt, and it wasn’t working for them. Every time they get to the place where they’re making headway, something comes up, and they have to borrow money to manage the emergency.

The guy’s point was that he can’t get out of debt because LIFE KEEPS HAPPENING.

The columnist’s advice was milquetoast. The condensed version would be something like, “Yeah, dude. Life is hard. But, hey… You’ve got the right idea. Be patient with yourselves. Keep on, keeping on. You’ll beat it eventually.”

I’m like “What???!” At the rate this couple is going, they may never get out of debt.

In his letter to the columnist, the guy said he and his wife were concentrating on paying down his debt rather than saving. His reason was that they were paying a lot of money in interest. Well, he’s correct on that point: Interest drives up the cost of debt. But, he admits they’re caught in a cycle of paying and then borrowing again. Their plan is not working.

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I appreciate this couple’s decision to become debt free. I admire the effort they’re making towards attaining that goal, but in contrast to the columnist, I know they need to change tactics. They need to build an emergency funds account.

If your plan is not working for you, it’s time to change the plan. Sit down and examine the pattern that happens over and over again. What’s not working? And why? What constitutes an emergency is an important thing to consider. We need to distinguish the difference between a true emergency and an inconvenience. An emergency must be addressed; inconveniences should not be allowed to control finances (or emotions). Do some critical thinking. Work out a new set of financial rules.

The number one rule in dealing with emergencies is to have emergency funds, and of course, this means having a budget. (I’m sure you knew I’d recommend that). When you have an emergency funds, you greatly reduce the need to finance (borrow) your way out of a disaster. By using their own funds, this couple will break the cycle of having to start over every time life happens.

They need to put emphasis on building an emergency account (saving funds designated for this). If they don’t have their own funds, every time something comes up they will acquire more debt. (They’ve already told us that’s what happens.)

What is an emergency account? What are emergency funds?

Well… Regardless of their origin, most emergencies have a financial aspect. An emergency account is money set aside to get through the emergency without the need to seek outside funding (getting a loan). An emergency account is for when life happens and you need additional funds.
In an emergency, if you don’t have the funds to get through, you have to get money from somewhere (usually in the form of a loan), or go without. Going without might not be a choice—you’re facing an emergency. Without an emergency account most of us will borrow, but repayment of the borrowed funds may stress our finances to the point of emergency. It can be a vicious cycle.

Many financial counselors advise setting aside the amount of money you need to live on for six months.

That’s a very good idea. But…

That kind of money isn’t accumulated overnight.

And while you’re saving, you’re still paying interest on the money you’ve borrowed.
I think a better plan for the present is to aim for a partially funded emergency account. Save and designate for emergencies about $1,000. Or, you could save an amount equal to what the last disaster cost you; take the choice that will provide the greater sum. And yes, it’s true with this plan also: While you’re focusing on building your emergency fund, your debt repayment needs to be at a very moderate rate. That means interest payments will remain greater for a while, but until you have some significant funds set aside for emergencies, you set yourself up to need to borrow again. And what will that do for you: Increase your debt and the cost of repaying it.

On the upside—once you have some funds to offset the need to borrow, you can develop a budget based on a balance between saving and paying down debt.

The number one reason to become debt free is to lower your cost of living. If you woke up tomorrow and had no consumer debt to pay, think about how much more financial freedom you would have. You would have money: Money to buy things: Money to do things: Money to save: Money to improve your future—because you wouldn’t be paying for your past.

Really, there’s no debate as to the importance of an emergency account in being debt free. If you are debt free, an emergency account will help you remain debt free. If you aren’t debt free, an emergency account can help you avoid greater indebtedness.

If you are in a Debt Free vs Emergency Account conflict—as in which comes first—consider this: An emergency account is an insurance policy against future indebtedness.

 

Emergency funds are an insurance policy against future indebtedness.

Emergency account, then debt free

The couple addressing the advice columnist is trying to become debt free. Figuratively, they are throwing money at their debt, trying to make it go away. Unfortunately, they are not making the progress they expected. The reason they aren’t successful is that every time a crisis comes along, they acquire more debt to manage the emergency. If they had an emergency account with funds to cover unexpected expenses, they wouldn’t have to incur more debt in these events.

Their plan should follow a course something like this: As of now they need to cut the amount of money they send their creditors. They do need to make payments at least a little greater than the required minimum, but a substantial amount of what they were paying needs to be redirected into building an emergency account. After their emergency account is funded, they can begin to aggressively pay off debt. When the next emergency occurs (and it will), they can use funds from their emergency account to manage its financial aspect. After the crisis has been handled, they’ll need to shift their attention and efforts back to rebuilding the emergency account; funnel funds into it as quickly as possible. This means they will temporarily reduce their debt payments to little more than the minimum. When the emergency account is replenished, they can (again) begin to aggressively pay down the balance of their indebtedness. The couple would need to follow this pattern until they were debt free. By managing their finances this way, their debt would in general decrease, and during times of an emergency the debt would not increase as it had in the past.

There is one variation on this plan that some find very effective: After their debt is significantly paid down (which means they must already have an emergency account that is at least partially funded), they choose to moderate their rate of repayment for the purpose of contributing to their emergency funds. This practice does extend the period of indebtedness, but it can strengthen the one’s overall financial position. The choice of this option has to be made case by case based primarily on income and budget.

Conclusion

I’ve talked about why an emergency account should be established before you begin an aggressive campaign to pay off your debt. There is no ideological battle of debt free vs emergency account. An emergency account is a very solid first step to becoming debt free.

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