Emergency fund if in debt with a good credit score

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Emergency fund series: in debt, with a good credit score

I previously have written about the emergency fund on moneystepper. There is so much debate on this in the personal finance world, and my opinion is different to what is considered to be the standard approach. However, (as most people do), I believe that my opinion is actually right.

Therefore, it seemed like it was necessary to write a more comprehensive post on the matter, discussing the ins and outs of the emergency fund for people on different steps of the wealth ladder.

 

 

What is the current “norm” for emergency funds?

The general thought for the emergency fund is that everyone should build an emergency fund of anywhere between 3 and 12 months of expenses. The amount will depend on the “security” of your income (although this will often be tricky to determine).

Most experts suggest that before people they start paying down their debt, they should have this emergency fund in place.

Others are slightly more flexible. Dave Ramsey, for example:

  • Step 1: Save £600 ($1,000) in a “starter” emergency fund
  • Step 2: Pay down all of your non-mortgage debt
  • Step 3: Create a “fully funded” emergency fund

In general, people suggest that the emergency fund is held in liquid cash (in current or checking accounts), so that it can be accessed immediately.

However, I don’t think that any of this is right and people could be losing a lot of money in the long-term by following this approach. Additionally, there definitely isn’t one single approach that works for everyone.

This is such a detailed topic that I’m actually going to write a series of article for the following different people at different stages of their financial journey:

  1. People who are currently in debt – good credit score
  2. People who are currently in debt – bad credit score
  3. People who are not in debt and have a positive net worth

In today’s article, we will discuss the first group of people.

 

What does it mean to be “in debt”?

Before we start, I have to make three points to note regarding my definition of “in debt”:

  1. If you have mortgage debt on your own home or on income producing real estate and your interest rate is below 6%, then do not include this in your debt. Given average market returns, you will be mathematically better off by keeping this debt rather than paying it down. For more details: “Buy a house in cash or take out a mortgage”
  2. If you have student loans with interest rates of below 4-5%, then the same theory apples as per your home mortgage above.
  3. If you have existing debt with high interest rates (credit cards/store cards), consolidate your existing debt onto an interest free credit card (with a long term interest-free rate and the smallest transaction fee possible) before you start your pay down

So, after these rules, you are in this category if you have consumer debt of over 6% interest rate (or any cards with 0% introduction rates), but also you have access to additional credit if required.

In this case, there is one short motto to remember: “Being in debt IS the emergency”.

 

People who are currently in debt – good credit score – recommendation

Emergency fund in debt good credit score

 

My recommendation for you is the following:

  • Use a long-period 0% balance transfer card as your emergency fund
  • Ensure that you have at least 3 months of expenses in currently available credit card limit
  • Have 12 months of expenses available through additional borrowing

This may sound crazy to you. You are in debt, and I am suggesting to you that you should go further into debt if you have an emergency. Well, in short, yes I am. The reason for this is that the additional spending above will occur if you have an “emergency”. This, by very nature, is an infrequent event that we are not expecting to happen. Therefore, most of the time, putting your available cash to paying down your debt will be beneficial compares to holding your cash in a very low interest bank account.

I think we can understand why by looking at an example.

“Adam had credit card / store card debt of £11,000, which was at an average interest rate of 18% APR. He has performed a balance transfer to a new card with a £15,000 credit card limit (0% interest rate for 30 months, with a 3% balance transfer fee and interest rate on new purchases of 15% -> £330 fee paid to be added to his debt). His monthly expenses are £1,200 per month. He has a very good credit score and therefore access to additional borrowings if required”.

Adam has started well, moving his debt to a zero interest rate card. He now has 30 months where he will not be paying interest and hence can place all his cash into paying down this debt. However, he doesn’t actually have to pay it off until month 30, and hence he can use his “final repayment amount” as his emergency fund in the short-term.

Adam has determined that he has £400 per month which he can attribute to his emergency fund and/or debt repayment.

This cash will be put into an account to pay down the debt after 30 months. This account should also act as his emergency fund if something terrible was to happen. If the emergency is for less than the amount in this cash account, Adam will use his cash account. If it is more than the amount in this account, then he should use his credit card and pay of this amount as quickly as possible. If the emergency is huge, then he should take out additional borrowing to pay the emergency (if it is absolutely essential).

 

 

No emergencies occur during the 30 months – only well budgeted expenses are incurred

1)      Standard approach (save 3 months in emergency fund, then pay down debt)

In the scenario, Adam would pay £400 to his emergency fund for 9 months to build up 3 months’ worth of expenses. He would then place £400 against his loan until it is fully paid off.

Result: debt will be paid off after 52 months with total interest paid of £6,141.

 

2)      Dave Ramsey approach (save £600 in an emergency fund, then pay down debt)

In this second scenario, Adam would pay £400 to his emergency fund for 1.5 months to build up £600 starter emergency fund. He would then place £400 against his loan until it is fully paid off.

Result: debt will be paid off after 39 months with total interest paid of £3,718.

 

3)      Moneystepper approach (consolidation to a 0% credit card with small fee – see above)

Using the moneystepper method, Adam would pay £400 into his “future debt paydown” fund each month. In month 30, he would pay down the debt in total. We shall consider a 3% balance transfer fee as the equivalent of “interest”.

Result: debt will be paid off after 29 months with total interest paid of £330.

 

Minor emergencies occur during the debt period – £500 emergency twice per year

1)      Standard approach (save 3 months in emergency fund, then pay down debt)

In the scenario, Adam would pay £400 to his emergency fund for 9 months to build up 3 months’ worth of expenses. When an emergency occurs, he would use his emergency fund, build this back up to the 3 months level, then he would then place £400 against his loan until it is fully paid off.

Result: debt will be paid off after 79 months with total interest paid of £9,270.

 

2)      Dave Ramsey approach (save £600 in an emergency fund, then pay down debt)

In this second scenario, Adam would pay £400 to his emergency fund for 1.5 months to build up £600 starter emergency fund. When an emergency occurs, he would use his emergency fund, build this back up to £600 level, and then he would then place £400 against his loan until it is fully paid off.

Result: debt will be paid off after 52 months with total interest paid of £5,072.

 

3)      Moneystepper approach (consolidation to a 0% credit card with small fee – see above)

Using the moneystepper method, Adam would pay £400 into his “future debt paydown” fund each month. In month 30, he would use his entire “future debt paydown” against his remaining debt amount on the card, and continue to pay down his debt until it has gone. We shall consider a 3% balance transfer fee as the equivalent of “interest”.

Result: debt will be paid off after 35 months with total interest paid of £411.

 

Minor & Major emergencies occur during the debt period – £500 emergency twice per year and one £3400 emergency after 12 months

1)      Standard approach (save 3 months in emergency fund, then pay down debt)

In the scenario, Adam would pay £400 to his emergency fund for 9 months to build up 3 months’ worth of expenses. When an emergency occurs, he would use his emergency fund, build this back up to the 3 months level, and then he would then place £400 against his loan until it is fully paid off.

Result: debt will be paid off after 100 months with total interest paid of £14,436.

 

2)      Dave Ramsey approach (save £600 in an emergency fund, then pay down debt)

In this second scenario, Adam would pay £400 to his emergency fund for 1.5 months to build up £600 starter emergency fund. When a small emergency occurs, he would use his emergency fund, build this back up to £600 level, and then he would then place £400 against his loan until it is fully paid off. When the major emergency occurs, Adam could use £600 from his emergency fund, but the remaining £2,800 would need to be added to his loan.

Result: debt will be paid off after 74 months with total interest paid of £8,510.

 

3)      Moneystepper approach (consolidation to a 0% credit card with small fee – see above)

Using the moneystepper method, Adam would pay £400 into his “future debt paydown” fund each month. In month 30, he would use his entire “future debt paydown” against his remaining debt amount on the card, and continue to pay down his debt until it has gone. We shall consider a 3% balance transfer fee as the equivalent of “interest”.

Result: debt will be paid off after 46 months with total interest paid of £940.

 

Summary of cost of getting out of debt

Based on the three repayment methods in our example for Adam, we have the following total amounts of interest paid whilst trying to get out of debt:

 

Method No emergencies Minor emergencies Major emergencies
Standard £6,140.81 £9,269.51 £14,436.01
Dave Ramsey £3,718.31 £5,072.02 £8,490.65
Moneystepper £330.00 £410.53 £940.31

 

 

Conclusion – In debt with good credit rule

If you have consumer debt of over 4-6% (depending on its nature), you should consolidate your existing high interest debt onto a 0% card and use this as your emergency fund whilst paying down the borrowed amount before the end of the debt period.

 

 

Other categories

If you find yourself in another one of the categories mentioned above and want to see a comparison for your emergency fund options, check back on moneystepper of the coming fortnight where I will be covering each and every example.

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8 thoughts on “Emergency fund if in debt with a good credit score

  1. I like Dave Ramsey’s approach since saving $1,000 or £600 keeps you save from at least 90% of emergencies (I’ve read). I don’t use a CC as a line of credit so I keep around $1k liquid. I have quite a few streams of income so I’m not worried about losing my job, blowing through my savings, and going into a tailspin.

    Nice post.
    Will Lipovsky recently posted…Can Money Take My Passion to the Next Level?My Profile

  2. I love Dave Ramsey and I think everything that he says is true. Having an emergency fund is so comforting to have. You never know if you will have health problems, job loss, etc. Having that back up fund makes life just a little bit less stressful.
    Chad recently posted…The Credit Score RangeMy Profile

  3. This is very interesting… I’ve been following the Dave Ramsey method with the emergency fund for the last couple of years. Presented like this, it seems that your way is more effective in terms of interest paid and the length of time it would take to pay off the debt.

    Out of interest what would you advise if the scenario was a couple who are in debt trying to tackle their debts together. They have joint finances so one emergency fund but separate debts. One person has a good credit score and the other has a bad credit score… I ask this because this is what happened with myself and my husband! We’re almost there now with our debts but I’d be interested to know what you think about this.
    Hayley @ Disease Called Debt recently posted…Are you a Debt Free Wannabe or Debt Freedom Achiever?My Profile

    • Good question Hayley.

      This is a personal decision for everyone as people choose to handle their finances within a marriage differently. I’m personally of the school of thought that, once married everything should be shared.

      Clearly, the mathematically sound approach is to use the person with the good credit score to obtain the available lines of credit and then nothing much else would be different against the scenarios presented above.

      Thanks for the comment and for taking the time to read the post.

  4. Having emergency fund is such a great thing to do. It’s better to be financially prepared to what might happen in the future, we don’t know when will it be and what will it be. Through e-fund, our future can be secured and reduce the risk of having debt.

  5. Hey Moneystepper, I think you hit the nail on the head here, but more for unwritten reasons. When it comes to paying off debt and starting an emergency savings, we all know we should do it. However, depending on your level of debt, your level of savings, and your ultimate goals, the way you should go about it will differ from others. I think that looking at other options as you have, and building your own, again as you have, will generate a far more effective strategy.
    Josh @ CNA recently posted…Are You Oblivious To Geopolitical IssuesMy Profile

  6. Very interesting to see it laid out this way. I’m certainly in the category you’re addressing here, and I go back and forth about hanging onto my emergency fund, and using it to pay down our substantial debt. It feels silly to sit on any sum of money while working to pay down a lot of debt, but the thought of not having an emergency fund is a little terrifying…
    Amy recently posted…SavingStar Friday Freebie: One Roll of Scott 1000 Bath TissueMy Profile

  7. I’m trying to digest your post and apply it to my situation. Our consumer debt has been consolidated onto our mortgage and we are paying 2.79% with a plan to have it paid off in 4 more years. We want to get this paid during this timeframe as we are approaching our retirement years (54 and 61 currently). So we are lower than the 6% you quote, already. As part of our strategy, I do take out 0% balance transfers at 0.99% interest for 11 months for about 25K and apply that directly to this mortgage debt. I pay it down monthly. I have our emergency fund established – 5 months is in tax free investments, 1 month in cash (almost, I’m about 2K shy ATM).

    I’m a bit confused on how to apply your method to our situation. I think you would say forego the emergency fund and apply it all to debt, and take out a 0% interest balance transfer and use this as the emergency fund if needed. Don’t pay it back until the it is due, but save up the amount needed to pay it back over the duration. If we have to save up for this though, it will cut into our ongoing debt repayment and this could be mentally challenging. Is what you are saying, what until the emergency happens and then deal with it? Again, not sure if I would be comfortable with this, because I want to know that we’ve got the worst case scenarios covered and that my husband will be able to retire in 4 years, not 4 years and 6 months. I maybe missing something though about your method, so kindly point me in the right direction. Thanks!
    debt debs recently posted…Debt Update and MVP Blog AwardMy Profile

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