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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

 

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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