The Debtor's Dilemma
Picture this debt nightmare. You have just created your first net worth statement and you have decided that priority one is to pay down your debt, but you agonize over sending every last cent toward your outstanding debts because you have nothing in savings. You also have read 68 books on personal finance and know that you are supposedly to have at least 3 to 6 months set aside in an emergency fund just in case you have, well, an emergency.
So what do you do?
I come across this question so frequently, that I had to write an article addressing the situation.
An emergency fund is definitely a must have in terms of financial security. You really should NOT start investing in anything until you have set aside some money for the unforeseen expenses that are part of life.
On the other hand, you also know that paying down high interest loans and credit card debt is also an important step towards building your secure financial house.
So which is better: paying down your debt or building your emergency fund?
And which is best for you? Read on to find out.
In order to answer the question of which option is better, paying down your debt of funding your emergency fund, I think you have to look at three main areas:
Return on Investment, Stability and Peace of Mind
Return on Investment
If you pay down debt with your extra monthly cash flow, you will get a better return on your money than if you funneled it into a low-risk, low interest payment savings or money market account. When you pay down high credit card debt you are effectively earmarking whatever rate of interest your credit card charges you.
If you are paying 15% -20% interest on your cards, I seriously think there is anyone who could come up with an investment option that would provide those returns guaranteed.
WINNER: Paying down your Debt
What do I mean by stability? I mean to ask you how stable your financial life is and can you weather a storm of unforeseen expenses.
You do not want a blown boiler or doctor bill derailing your financial freedom plan. Having a kitty of cash set aside is important to pay for those unforeseen expenses. But getting your debt to income ratio lower is just as important.
If you lower your total outstanding debt, you should be lowering your monthly minimum payments, so increasing your free cash flow.
Peace of Mind
For years I lived paycheck to paycheck and I was miserable. Instead of having a well-funded emergency fund, I decided to invest a set amount each month into mutual funds and then I spend whatever was left over. I had maybe a month or two of living expenses set aside in a savings account.
One winter my car died on me and I had to buy a new one, which wiped out my savings and added a new monthly expense. Several months later I barely had enough cash for a wedding present for one of my closest friends. It was then that I realized that I had to make some changes.
So what did I do? I became more responsible course!
I quickly cut back on most of my frivolous expenses and started building up my reserves. By the end of the year I had several months of living expenses set aside and today I can sleep at night with no worries of missing a payment or defaulting on my loans.
WINNER: Funding your Emergency Fund
So we have a tie. How do we break it?
You decide what's best for you.
So what option is best for you?
So which of the above three are most important to you? If you want to get out of debt as fast as possible and don t care if you have an emergency fund, you would be best served if you use all available funds for paying down debt.
If you toss and turn at night thinking of that mountain of debt you are carrying every day, you might sleep better knowing that if you lost your job you have cold hard cash set as well as pay your bills for the next six months.
Why not do both?
So why bother choosing either one? Why not do both?
This is what I did and I am sure it looks like a copout, but you get the best of both worlds when you attempt to do both at the same time. You also get the satisfaction of knowing that you're paying down your bad debt and you get the peace of mind that comes with having a little change in your pocket.
Hey, You do not need to save 3 months right now!
When I first work with people on cleaning up their financial house, they instantly gasp and make this funny look on their face when I suggest that they need to set aside 3 to 6 months of living expenses. "I can not save that much" or "What about paying my debt off?" they'd ask.
Yes, it s true that 3 or 6 months of expenses is a lot to set away, but the truth of the matter is that you do not have to set the 3 months away tomorrow. You can do it over time.
Start small by immediately saving enough for one month's expenses. This is an arbitrary number of months, but it is a good starting point to shoot for. In the meantime, pay the minimum on your credit cards if you have to, but save enough for that one-month's worth of living expenses.
Then when you have gotten that saved up, deposit a set amount each month into your emergency fund and plow the rest of your free cash flow into paying down your debt.
Building your emergency fund dollar by dollar
If you skip a night out on the town, put the money you would have spent into a cash can (a plain old empty coffee can or jar will do). When you cook dinner instead of going out, put that money into your cash can. Every night put your spare change and a little extra into your emergency fund. Repeat often.
Every weekend, go to the bank and deposit that money into your emergency fund account. You can choose to wait until you have enough money to roll your change into packs that your bank likes. Avoid those change machines at the shopping center. They charge you close to 9% for the privilege of counting your money ie, doing something you could easily do.
Now you are well on your way to building your emergency fund and paying down your debt. Once you have three or four months of living expenses set aside, start accelerating your debt repayment plan.
I am Paying Down My Debt, But I Have NO Free Cash Flow
What if you are living right to the edge and do not have much money set aside?
Hold the mother of all garage sales, take on another temporary job, scale back your living expenses, move to a lower cost neighborhood, sell your expensive car and buy a used one (read: cheaper one). All of these are things friends of mine have done, so I know that they can be done.
The key is to commit to your goal of funding your emergency fund and make it priority one. That means it is more important than that latte at Starbucks or going to see the latest blockbuster movie.
Stay focused and committed to your goals and think of ways to cut your expenses.
Create that debt repayment plan and stick to it.
One day you will wake up from a wonderful night's sleep and find that your bad debts have been paid off and you have enough money in your bank to weather a financial storm. It is a dream I have often, but it is a dream I am actively working toward making into reality.
I hope you will create your debt repayment plan today, put it in motion and start dreaming of that day as well.