Jeff

I agree with the mathematics of your argument, however there are some expenses that need to be paid in cash and people with financial problems might have already used ther cash advance limit on their credit cards. I think it is prudent to have a small emergency fund for things like rent or home repairs that just can’t be paid by credit card. Plus I think for many people using the credit card is addictive and once you start charging for emergencies it is easy to use it for day to day expenses.

Great article. But what if I have say $3000 on a 0% APR card for 1 year or so. Isn’t it better to just keep paying the minimum and use that money for emergency fund or investments?

Wow, you sure went great lenghts to explain your point of view. The question may not really be that cut and dried, though. Each individual’s circumstances are different and there may not be one right answer for everyone. Thought provoking stuff!

The “credit-card debt before savings” argument has always seemed very straightforward to me, but right now DH and I are trying to figure out the answer to the “student loan or savings” question. The interest rates are much closer, which makes the financial advantage much less clear, and unlike credit cards, if we have no savings and disaster hits, we can’t just tap our student loans for more funds. Right now we’re compromising with a fifty-fifty split of our extra funds.

Ah, the things we ponder.

Good example…you might want to throw in what each paid total to their credit card company in all scenarios

“I agree with the mathematics of your argument, however there are some expenses that need to be paid in cash and people with financial problems might have already used their cash advance limit on their credit cards. I think it is prudent to have a small emergency fund for things like rent or home repairs that just can’t be paid by credit card. Plus I think for many people using the credit card is addictive and once you start charging for emergencies it is easy to use it for day to day expenses.”

Obviously if someone has a large amount of credit card debt, there is a financial problem that needs to be resolved. While I understand what you’re saying, I would counter that by paying down the credit card debt it will open up the cash advance limit (in case there is an emergency) and it is just as easy to begin using your “emergency fund” for day to day expenses as it is a credit card.

My point is that when you have credit card debt, you really can’t have a true “peace of mind” and in many cases it’s detrimental to your finances to build an emergency fund and think that it is helping you financially.

“But what if I have say $3000 on a 0% APR card for 1 year or so. Isn’t it better to just keep paying the minimum and use that money for emergency fund or investments?”

Of course you’re talking an entire different ball game in this situation.

“The question may not really be that cut and dried, though. Each individual’s circumstances are different and there may not be one right answer for everyone”

I completely agree. I would never suggest there is a single answer for anyone and it is always important to take into the particulars of your situation when making a financial plan. I just feel that there are a lot of people fooling themselves thinking that an emergency fund gives them something that really isn’t there and it’s important to realize how much it costs.

“DH and I are trying to figure out the answer to the “student loan or savingsâ€? question. The interest rates are much closer, which makes the financial advantage much less clear, and unlike credit cards, if we have no savings and disaster hits, we can’t just tap our student loans for more funds. Right now we’re compromising with a fifty-fifty split of our extra funds.”

Certainly the interest you pay on the debt makes a huge difference as the 0% credit card comment would indicate. You are also correct in that unlike paying down credit card debt which frees up your limit, paying student loans and other debt does not allow you to take that money out in the instance of an emergency – and you are wise to try and balance it.

Credit card debt is the devil I’d prioritize getting rid of it. Take a night and weekend job. Just purge that debt.

[...] Credit Card Debt vs Emergency Fund by Jeffrey Strain at Personal Finance Advice looks at whether you really have an emergency fund if you have credit card debt. [...]

I think it’s good to pay down credit card debt, especially if the interest rates are high. Or better yet, use 0% balance transfer like Floyd mention to pay down the debt. Like you said, the emergency money in the bank is not really emergency money because you still owe the money and paying high interest rates compared to the bank.

Links and Minifeatures 01 30 Monday

Carnivals:

Carnival of Personal Finance. Recommended:

To the first commenter (John Mackenzie): you’re absolutely right, some things such as rent do need to be paid in cash rather than put it on credit card in the event of an emergency cash shortage. But you can still put all your savings into paying off credit card debt rather than building up an emergency cash fund – apply for a line of credit. This can be your “emergency fund” until you have paid off the CC debt. If you don’t use it, it costs you nothing. So, only use it if you literally RUN OUT of cash due to emergency.

Ah, the long-debated issue of credit card (or bad) debt vs. savings (or emergency fund). We’ve all heard the saying “pay yourself first“.. so why aren’t we doing that in this situation? The commenters above have brought up excellent points, including the comparison between APR interest rates being charged on the CC (or other debt) versus APR yield of a savings account, for example, as well as different circumstances where drawing off the line of credit would be impossible or unprudent.

The theory behind Jeffrey’s article is simple. You want to allocate your money (income and savings) toward the investments that will yield you the highest rate of return. Unfortunately, credit card and other bad debt is actually NEGATIVE (-) return. So if you’re paying off a credit card with say, 10% APR, any money you place into another investment such as a savings account or stocks, for example, would have to ACHIEVE a 10% APR yield in order for you to just BREAK EVEN, not including transaction costs, etc. As such, the best idea is to pay off your NEGATIVE return items as fast as possible, fighting the power of compound interest that the credit card companies will charge you. The more money you put in the credit card, (1) the less interest you will be charged per month, so you will be able to in effect ’snowball’ your payments as more and more of your monthly payment is applied toward the principal, and (2) the faster you pay it off, the sooner you can invest into positive-yield items such as a high-yield savings account for those emergencies, or into an investment portfolio. Thus the scenario Jeffrey mentioned above.

Now, in addressing the exceptions to the rule and the issues brought up:
1. John Mackenzie mentioned the fact that yes, some things in life requie cash. And also brought up the prudent point (albiet indirectly) that perhaps using your CC’s CASH AVANCE may be a BAD IDEA. Why? Because most credit cards will charge you way HIGHER interest for that cash advance, and guess what? The tiered payment setup that they use to maximize their gains is that any principal you pay on your credit card will get applied to the purchases with the LOWEST APR. So even if you have for example a 0% APR card and its filled up halfway, but you do a CASH advance, guess what? Your payments won’t go toward your high-intereset cash advance, but toward the 0% balance you owe first. *NOTE* Check with your credit card company for the specific details, but that has been my experience as well as many people I know.
Solution: Develop a budget. Rent should not be an “emergency” because you should have already accounted for that in your monthly budget.
2. Addressing the issue of 0% APR furthermore: Yes, if your credit card has 0% APR, and your balance is fully within that 0% APR, then using the best investment yield rule mentioned above, YES. Pay only the minimum amount (for which each payment would go toward the principal) but DO NOT charge anything else or cash advance on that card. If you do, you will start carrying a negative APR yield in the form of interest owed. While you’re paying off the minimum, you can look for a high-yield savings account for those emergencies and start stashing away.
3. Student loans/non withdrawable debt: On the surface, this would appear to be a tricky subject. But as the posters above mentioned, it is best to balance your budget to include payments in while working on your emergency fund savings. If all payments went toward the loan, and you hit an emergency, you might have to take a high-interest loan to pay it, which would be counterproductive. So it only makes sense to balance your payments. Plus those loans tend to have lower interest than credit cards.
4. Laura’s comment about APPLYING FOR A LINE OF CREDIT. Unless the emergency comes and there is absolutely no alternative (re: borrowing from family, friends, or even *gasp* using the CC), I would not recommend it. Why? Because the last thing a creditor wants to see is someone who owes a significant amount of money in the form of credit cards apply for MORE credit. It can hurt your credit score, which can have long term consequences. NOTE: Again, check with a financial advisor or credit reporting agency for how this applies to your situation.

Long comment, I know.. but here’s the Cliff notes
1. Develop a monthly and yearly budget which includes payments for living expenses such as rent, phone, utilities, etc AS WELL as credit card and other bad debt. Also include a section in the budget for “savings” or “emergencies”. Now you know how much you absolutely need to spend every month. Allocate any windfall cash or spare money toward the highest-interest debt. Furthermore, create a debt-amortization schedule, so you know how long, with your current monthly payment, it will take to pay off your debt.
2. Always pay off the highest-interest debt first.
3. Stop the bleeding. Don’t charge any more on your credit card, especially if the new charges will have higher APR interest.
4. Stick to your budget.

It’s amazing how much BAD advice you can get out there on the internet from people who are far from being experts themselves. They say…..Don’t pay off balances in full at first in order to build credit, get a few store cards, etc….

This article spells out the truth, plain and simple. It’s nice to know that among all the bad advice, there is some good advice as well.

This is somewhat of an age old battle in the personal finance arena, emergency savings vs paying down credit cards.

I’m a big believer in doing whatever it takes to smooth out “CASHFLOW” which generally means having at least 1 months worth expenses saved up in cash. So that you always have a buffer that you can rely upon without having to once again dip into your credit card to bail you out.

I think that is the danger of not having a emergency cash fund, without something to back you up if your cashflow gets thin then it’s a big temptation to draw on your credit card limit that you have worked so hard on getting down.

If you have high interest credit card debt you need to get that paid off one way or another before the emergency fund. If you really want a smack in the face as to how much you are losing in cc debt each month goto bankrate.com and use the minimum payment credit card debt calculator. It is a big eye opener to the length of your debt and the money going towards interest.

This is 100% dead on except for a couple things!
1- Age and financial goals. If you already have a home and a plentiful retirement go for it. Pay off your debts. If your an Xer do not listen to any of this. Get the savings you need to purchase a home then concentrate on paying off the debt. Do not apply for a home loan until that debt is $0. I did this and I have to say it works out the best for us. Unless of course you have so much debt that you can’t save. Then I would suggest getting some financial help.
2- If your a boomer and have very little to live on and are ready to retire soon. Survival comes before any credit card, car loan, or any other debt you can think of. Put your self first not your debt.
3- New parents you may have made bad financial decisions but don’t make your kids suffer for your mistakes. A college fund comes before all debts. They are you and your future.
Many of you will hate me for this but the fact is money isn’t everything people are what makes this country great. People are the key here and a factor that is offten lost. Sometimes the numbers make sense but the fact is sometimes you have to put the good of others ahead of yourself. Good luck

The article was timely…for me…as I am struggling with the decision of whether to pay off debt first or create an emergency fund first.

I also agree with Steve F that what is important here is people. What is even more important is for people to analyze their relationship with money…in whichever form, for therein lies the culprit. If people can be honest with themselves and go back to that point in time when they started using credit cards and how they eventually ended up swimming in debt, they will be able to tell if they have a healthy, or unhealthy relationship with money.

Of course there is always living below your means and not placing our happiness in material things…. or in other people. We have all the answers, sometimes we just don’t ask the right questions.

[...] circumstances. One readers explains hers and is looking for advice: I just read your post about credit card debt vs. emergency fund. I completely agree with the concept and appreciate your example. I like numbers and they really [...]

Rather than argue with theory, I’ll present my own story. Anything perceived as financial or legal advice is for general educational and hypothetical purposes only and not intended as a substitue for sound professional advice. I’ve been going through a divorce, final just this week. When you truly love your wife and kids you tend to do stupid things to make them happy. We bought a $125k house in 2005, with $6k down/closing (our entire savings). The plan was I would work ($50k/yr) while she was an at-home mom. She didn’t take well to domestic life and started leaving my kid with her mother so she could go out and have fun by herself, often past midnight.

3 months after moving in, I asked if she was having an affair. 2 months after that she came clean and wanted a divorce. She also handed me a credit card bill for $5k of goodies she bought her boyfriend. This after I buy a $2k TV @ 0%/2yr financing to keep her happy at home with the kids, and a $3.5k whole house water purifier she “had to have” at a low rate. Housing market collapses on the same day. At this point there is no real disposable income. Lawyer would cost $5k min, she would still get custody (most likely), I would be stuck paying 25% child support, she gets to keep home while I’d be FORCED to pay full mortgage for at least several months, and pay at least 50% daycare, which would end up 100% for the practical reason that she had no income. Making up
made more financial sense, but then she wreaks her car. Car’s value probably $4-5k max (all paid off), and I was “saving” money on insurance by only carrying liability. Decide to have a community college “fix” the car for $1200, which becomes $1500, then spend another $1200 to get the “fixed” car a suspension system, because it is technically possible, though extremely uncomfortable, to drive without one. Car still leaks when it rains.

Still I hang in, relationship seems to improve, some debts start to pay down, though it seems that I keep spending too much to keep her happy (”oh hunny, our kid just has to have this brand new baby furniture. I won’t have used furniture in my house. Do you care more about money than your own kid?”) … and so on. During this make up time, she miraculously conceives another child – no pill can hold her back. Is it mine? I find more evidence of a new affair (which turns out to be valid). I decide to divorce – but can’t divorce when a child is on the way. I pay $7k retainer anyway to get the ball going, then (like an idiot) change my mind when she makes a new set of promises. Only 4 days after paying retainer, I get $2k refund. Now more debt. It gets better. My son is born (mine – thank God!), but while our doctor is in our insurance plan, and so is the hospital, the neonatal guy (who we never met nor even knew would be involved), sends us a kind letter advising us of our responibility to pay him $2k out of our pocket becaues he doesn’t participate in our plan. His services were mandated by the State of Texas. More debt again.

Soon, I’m alone with the newborn while she goes out at night, then gets MY car totalled. Other guy’s fault, but now no car to drive. His insurance pays, but I use the money to pay off debt and borrow my brother’s 2 passenger truck. Kids are stuck at her Mom’s because I can’t fit both in the truck while wife goes out with her car. Soon after, wife gets caught up in a scam, gets me involved in the scam by not telling me important information that could have saved my rear, then I end up facing a potential $30k bogus debt. I pay an attorney $3k “non-refundable” retainer, but at least send the crooks and potential creditors running for cover. Finally decide enough is enough, but need a car to drive both my kids, need to pay for daycare, need to get rid of house. Spend months with DIY repairs to get home ready for sale, then shop for a car that I can drive for a long time with little worry of it breaking down. Brother demands truck back, and wife nags about what car I can/can’t get. End up buying a very good car in excellent condition, 1 year old, 20k miles for $16k even, including 2 yr warranty, TTL, and all the extras, all for $240/mo payment @ 10%. Also stuck paying $1k/mo child care for 5 months while paying full mortgage and car payment, but at least taking care of kids on my own.

Eventually house finds a buyer, but then foundation instantly crumbles and hot water heater dies before closing. Finance $5k for foundation repair, and $1k for water heater + other plumbing. Sell house for $127k, but have to bring $2k to closing (yes, net loss after expenses, before even counting repairs).

Now homeless single dad, but living in my brother’s vacant home. Have nice car till ex-to-be tells judge she needs my car for “medical” purposes – she needs the tinted windows because of glare at night-time. Her car is in her own name only, the new car in my own name only, but judge reverses ownership. Who cares – I still get a car and my kids, and $60k of debt to pay off on my own. I’ve kept a $10k emergency fund from the start of my divorce and NO REGRETS.

I’ve paid almost $10k in legal fees, while at the same time the credit card companies didn’t appreciate my on-time minimum payments and kept reducing my credit limit each time I built up one or two thousand in “available credit” while paying off debt. I had one card as backup that I didn’t even use for 1 year, then got a cancellation letter due to my debt-to-income ratio. Another card sent an amendment in the mail to let me know they were going to double my interest rate unless I opted out, which meant that I wouldn’t be able to use the card anymore, and the account would close once the balance was paid off.

LESSON: If you EXPECT emergencies, you need an EMERGENCY FUND, not an emergency card! If I didn’t keep real cash on hand, I would have lost the only good thing I had going for me – custody of my children. I encourage my ex to see the kids as often as she pleases, which is one night per week.

If you have a lot of debt, you should spread it equally among as many creditors as possible to reduce the ability of one creditor to screw you over. Keep a cash emergency fund that is equal to your highest debt balance with a variable interest, so you can pay it all at once should the credit card raise your rates to usery levels. Use automatic bill pay to keep them all on track and ensure that you never pay late (make sure you don’t pay too early, or they’ll put two payments on the earlier month then charge late fees and triple your APR because you were “late” on the next month).

FUTURE: In spite of my horrible debt-to-income ratio, I’ve managed to keep my rates low. Highest card is 11% APR, but I have a $7k balance at 4.99% for

life, and $6k for 8.99% for life. Student loan steady at 3.9%. There’s more to financial planning the pure growth. Just a couple of years ago, a portfolio of 50% equities and 50% real estate would have been a “sure thing.” Now you’ve lost 50% of what you put in. The only asset worth buying in today’s market is life insurance. Don’t buy it in your name, buy it in the name of an Irrevocable Life Insurance Trust. If you have employer paid life insurance, make
your beneficiary a revocable living trust, and designate through the trust who the beneficiaries will be. For me, it’s just my kids, and since minors can’t inherit money directly, this step is important for me. If you own a home, probably best to own it also through a living trust, as long as you make sure with an attorney that you won’t lose the homestead exemption. After I pay down a significant portion of debt (gone or almost gone), I plan to shop carefully for a whole life policy owned by an irrevocable life insurance trust so that my heirs can have something when I go without handing it all to creditors or the government in income and estate taxes (or just as bad – probate, which is a legal process about as miserable and expensive as a divorce). At the end of your life, most, if not all, of your life savings will be eaten up with deathcare and burial costs. In Texas those creditors can seize up to $15k of exempt property that no other creditor is entitled to. If you only have $15k worth of furniture, appliances, automobile, clothing, etc., they can take it all. If you have family living in your home when you die, they can inherit your homestead free and clear of debt, but what will they sleep on? Almost nobody, especially young people, takes asset protection seriously, and most people don’t even know of the dozens of asset protection strategies out there, but they always have the latest stock/bond/real estate tactics on the tip of their tongue. Don’t wait for a lawsuit to set up an asset protection plan – that would
be fraudulent transfer and then the creditors get to take everything your trying to protect.

For those who don’t think they need asset protection or an emergency fund, I would hate to see you spend three, five, seven or more years paying off debt, only to be hit with another financial bomb and forced into an unfair Chapter 11 Bankruptcy (no Chapter 7 for you, thanks to my former party’s changes to laws that were just fine before 2005).

My order of priority is:

* Basic needs (housing, food, transportation, public education, legal fees, mandatory expenses only – little or no “fun” until credit card debt is gone.)
* Stay employed and look for ways to make yourself more desireable to keep when the inevitale layoff decisions are forced onto your management.
* Emergency credit card when possible, plus at least 1 month basic expenses in emergency cash, preferrably equal to highest balance you owe one creditor.
* Asset Protection from potential creditors and high taxes (worst case, if they can’t find you they can’t sue you. For piss poor folks like me, forget the deductions and go for the tax credits. Use refunds to supply your emergency cash, then to pay down debt)
* Life insurance (as described)
* Minimal Retirement Savings (creditor, bankruptcy, and tax protected 401k and similar plans. Company match is free money – don’t pass up!)
* Education Savings (similar protection with 529 plan – start with maybe $50-$100/mo as long as you’re making at least minimum payments)
* Homestead Primary Residence (keep if you already have and sure about affording the payments. Bankruptcy may be better than foreclosure or short selling.)
* Basic exempt-property (in Texas you can own two firearms as exempt property. Own at least one – the repo man will see your weapon registered in the public records and will put you on the bottom of his list. He will be very busy with many other repossessions for the next year or so. If your fridge is about to go out and you still have credit available, buy one while you can, but not within 6 months before filing bankruptcy).
* Go to a coin dealer once a week or month and pay cash for one tenth-ounce Gold Eagle and a Silver Eagle. Keep the transation private and the coins in a safe place (not a bank deposit box, unless your renting a room and have no real physical security). Worst case – ride through any short duration of hyper-

inflation, which is very possible. You may not have three months to wait for your employer to catch up with the times once hyper-inflation sets in. This will be a good time to sell any non-essential hard-assets you’ve been holding onto (guns, jewelry, watches, tools).
* Pay off debt ASAP (after previous steps).
* Build your emergency fund to 3, 6, 9, or 12 months depending on what you think is safe. Consider online credit unions that can pay higher rates than what you see on bankrate.com. If a substantial amount of cash (say $10k or more, consider putting some in an off-shore bank, like Dubai, and talk to an estate planning attorney or a private investigator that can advise on privacy protection and asset protection. Use a laddering strategy of FDIC CD’s and investment-grade tax-free municipal bonds so that you earn the highest interest possible while making sure you have mature funds coming to you like clockwork when you need them.
* Save 20% down for a MODEST home that you can claim as a homestead if you don’t have one. Consider renting out rooms to accelerate mortgage payments.
* Max out your ROTH IRA, contribute more to 529 plans, spend a little more money on your asset protection and estate plans.
* Monitor you cash flow and make sure your net worth continues to grow debt free.
* Now you can start enjoying life. Sign the kids up for music lessons and go finish that degree or get that MBA, but stay away from student loans and home equity loans.