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

Following our post earlier in the week, we are still looking at emergency funds.

The first post in our emergency fund series looked at the possible scenarios when you are in debt and you have a good credit score.

Today, we look at the same scenarios, but for those people who are in debt but also do not have a good credit score.

 

 

What was the conclusion for people in debt with a good credit score?

We looked at 3 scenarios:

1. No emergencies happen during the debt repayment period
2. Minor emergencies occur – two £500 emergencies each year
3. Major emergencies occur – two £500 emergencies each year and one £3400 emergency after 12 months

In each scenario, we investigated the speed of debt repayment based on three methods of maintaining an emergency fund:

1. Standard: where you build an emergency fund of 3 months’ expenses before paying down debt
2. Dave Ramsey: where you build a £600 ($1000) emergency fund before paying down debt
3. Moneystepper: where you use available credit as your emergency fund

 

Based on the three repayment methods for a specific example, we noted 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	£9,249.23	£15,004.79
Dave Ramsey	£3,718.31	£5,072.02	£8,798.98
Moneystepper	£330.00	£409.32	£1,031.71

 

Therefore, we concluded that 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 available credit as your emergency fund whilst saving to pay down the borrowed amount before the end of the debt period.

 

A reminder of the definitions and the example

We will be using the same definitions of “debt” as for people in debt but with a good credit score:

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.
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 you have limited or no 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 – bad credit score – recommendation

In summary, my recommendation for people who are in debt, but with a bad credit score, is the following:

• Determine the amount of existing credit you have available. For example, if your credit limit if £5,000 and you currently have £4,800 on your credit card, your existing available credit is £200. This will be the total of all your available unused credit you have. It will not include any new lines of credit (as you will struggle to obtain these without a good credit score).
• Once your credit card hits the maximum limit, discuss borrowing from friends and family at a very attractive interest rate for both parties. Check out this article for an explanation of this and other much better alternative to payday loans.

 

As with the good credit score, the advantages of this method are best demonstrated through an example:

“Brian had credit card / store card debt of £11,000, which was at an average interest rate of 18% APR. The total available credit on these cards is £11,500. His monthly expenses are £1,200 per month. He has a very bad credit score and therefore has no access to additional borrowings. He has an agreement with his parents that, if he sticks to his repayment plans, he can borrow from them at an annual interest rate of 40%”.

Note that this 40% isn’t mummy and daddy enabling their child. This is an agreement which is beneficial to both parties. Clearly, Brian’s parents are taking some risk in their “investment”, but the 40% returns reflect this and both parties have entered willingly into the agreement. 40% is obviously very high to Brian, but this pales in comparison to some other options (unauthorised overdraft, payday loans, loan sharks, etc).

Brian has determined that he can put aside £400 each month towards repaying his debt and/or building an emergency fund.

 

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, Brian 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 53 months with total interest paid of £6,367.

 

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

In this second scenario, Brian 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, Brian would pay £400 against his current debt each month and any emergencies would be funded through his existing lines of credit (credit cards up to £11500 and parents at 40% APR after this).

Result: debt will be paid off after 36 months with total interest paid of £3,290.

 

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, Brian 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 to build this back up to the 3 months level, then he would place £400 against his loan until it is fully paid off.

Result: debt will be paid off after 77 months with total interest paid of £9,831.

 

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

In this second scenario, Brian 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 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, Brian would pay £400 against his current debt each month and any emergencies would be funded through his existing lines of credit (credit cards up to £11500 and parents at 40% APR after this).

Result: debt will be paid off after 49 months with total interest paid of £4,439.

 

Minor and 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, Brian 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 place £400 against his loan until it is fully paid off. When the credit card lending reaches the £11,500 limit, Brian will borrow from his parents at 40% APR.

Result: debt will be paid off after 131 months with total interest paid of £24,364.

 

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

In this second scenario, Brian 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 place £400 against his loan until it is fully paid off. When the major emergency occurs, Brian could use £600 from his emergency fund, but the remaining £2,800 would need to be added to his loan. When the credit card lending reaches the £11,500 limit, Brian will borrow from his parents at 40% APR.

Result: debt will be paid off after 71 months with total interest paid of £8,354.

 

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

Using the moneystepper method, Brian would pay £400 against his current debt each month and any emergencies would be funded through his existing lines of credit (credit cards up to £11500 and parents at 40% APR after this).

Result: debt will be paid off after 67 months with total interest paid of £7,263.

 

Summary of cost of getting out of debt

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

 

Method	No emergencies	Minor emergencies	Major emergencies
Standard	£6 366,73	£9 831,10	£24 363,66
Dave Ramsey	£3 718,31	£5 072,02	£8 353,78
Moneystepper	£3 290,15	£4 439,19	£7 262,66

 

Let’s not underestimate this! Brian starts with £11,000 in debt.

The difference between using the “standard” advice compared to the moneystepper method could be anywhere up to 4 and a half years of debt repayments, with additional interest repaid amounting to over £17,000. This additional interest is over twice what needs to be paid.

I can’t reiterate this enough: DEBT IS THE EMERGENCY!

 

 

Conclusion – In debt with bad credit rule

If you have consumer debt of over 4-6% (depending on its nature), and you do not have the credit score to refinance, you should still treat debt as the emergency. Pay down as much debt as possible and use your existing lines of credit (and other alternatives to payday loans) as your emergency fund whilst paying down the borrowed amount.

 

Other categories

So, we have now covered:

• In debt with a good credit score
• In debt with a bad credit score

In the coming days, we shall also review how the emergency fund should be managed for those people:

• Not in debt

 

Once again, and all together:

DEBT IS THE EMERGENCY!

 

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