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When it comes to whether you should begin an emergency fund before or after paying off your credit card debt, there is quite a bit of debate with many suggesting that an emergency fund is important for "peace of mind." The reasoning is that if you have cash in an account and an emergency arises, you then have the cash to pay for the emergency and thus don't have to place it on your credit card and go further into debt.
While this may appear logical on the surface, the concept is built on a false foundation. While having an emergency fund in a savings account once you have paid off your credit card and other high interest debts makes sense, having an emergency fund in a savings account while you still have credit card (or other high interest) is nothing more than paying the credit card company extra money. An individual can never truly have an emergency fund until all their credit card debt has been paid off.
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When it comes to your finances, you will come out ahead if you pay off your credit card debt as quickly as possible rather than building a savings account while still carrying credit card debt. Let's take a look a the same scenario with the two approaches:
Two individuals have $5000 in credit card debt at 18%. Both currently have $1000 in their emergency savings account. The minimum payment on both cards is $100 and each person has come up with a way to put aside and extra $100 a month. Individual A (Bob) wants to build a $2000 emergency fund to feel safer and have "peace of mind" before beginning to pay off the credit card. Individual B (Mary) decides to put all the money toward her credit card debt. Unfortunately 12 months after both of them begin their plan, there is an emergency that requires them each to pay $2000 - which one ends up paying off their credit card first?
<center><img src="http://www.savingadvice.com/images/blog/emergencyfund.jpg" alt="Emergency Fund"></center>
This is how the money situation evolves in each scenario:
Individual A (Bob):
Since Bob wants a $2000 emergency fund before paying off his credit card, he spends the first 10 months paying the minimum on the credit card and placing the other $100 into his emergency fund. This results in the credit card balance moving down to $4732.43 and him fully funding the $2000 emergency fund he wanted. For the next 2 months he pays $200 toward his credit card debt which brings the total down to $4472.47. Then an unexpected emergency occurs out of the blue costing $2000. Bob feels fortunate that he has the $2000 in savings to cover it and believes he made the right choice in building the emergency fund up for just such a situation. Since his emergency fund is now down to $0, he spends the next 20 months building the emergency fund back up to $2000 and only pays the $100 minimum toward the credit card. At the end of these 20 months the credit card balance has been reduced to $3711.40 and Bob once again has his $2000 emergency fund. He once again begins paying $200 toward the credit card debt and it takes another 22 months for Bob to completely pay off his credit card. In the end it takes a total of 54 months or 4.5 years to pay of the credit card plus he has $2000 in the bank. Bob ended up paying approximately $2800 in interest charges during this time.
Individual B (Mary)
Mary decides to bite the bullet and put all her effort into paying off the credit card debt without building an emergency fund first. She's a bit nervous because she knows she doesn't have any cash to pay for any emergency that might occur. She decides getting out of debt as quickly as possible is the most important thing and takes the $1000 emergency fund out of the savings account and places it toward the credit card debt. This brings down her credit card debt to $4000. For the next 12 months she pays the $200 a month toward the credit card debt which brings the total down to $2501.62. At this point there is an unexpected emergency that costs $2000 and since she doesn't have any money in the bank. Since there is no money in the bank, she is forced to place the cost on her credit card. This brings the credit card total all the way back up to $4501.62. She wonders if she made a mistake by not creating an emergency fund like Bob, but she continues to stick with her plan even with the setback. She continues to pay $200 a month toward the credit card debt and is able to pay off the credit card in full in 28 months. In the end it takes her 40 months (3.3 years). Mary then begins to place the $200 a month into a savings account for an emergency fund and comes out with an extra $800 ($2800) than Bob in her savings after 54 months. During this same period she pays approximately $2000 in interest to the credit card company.
If there is no emergency in the 12th month, the numbers are even larger in favor of Mary. Bob takes a total of 40 months (3.3 years) to pay off his credit card debt and has $2000 in the bank. Mary takes 24 months to pay off the credit card debt and after 40 months has $1200 more than Bob ($3200) in her emergency fund.
<center><img src="http://www.savingadvice.com/images/blog/credit-card9.jpg" alt="Credit Card as Emergency Fund"></center>
Both scenarios show that building an emergency fund before paying off credit card means paying more in interest to the credit card company. While it may give you a sense of "peace of mind" having money in the bank, as the above shows, it's a false sense that is actually costing you more money and extending the amount of time you'll remain in debt.
When you begin to pay down credit card debt, it frees up space under your credit card limit and this can be used as an "emergency fund." While the goal is to never use it, it is there if need be just as the money sitting in the savings account would be. This is using the credit card to your advantage instead of letting the credit card take advantage of you and that's ultimately the personal finance skill you want to develop to make the most of your money.
While this may appear logical on the surface, the concept is built on a false foundation. While having an emergency fund in a savings account once you have paid off your credit card and other high interest debts makes sense, having an emergency fund in a savings account while you still have credit card (or other high interest) is nothing more than paying the credit card company extra money. An individual can never truly have an emergency fund until all their credit card debt has been paid off.
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When it comes to your finances, you will come out ahead if you pay off your credit card debt as quickly as possible rather than building a savings account while still carrying credit card debt. Let's take a look a the same scenario with the two approaches:
Two individuals have $5000 in credit card debt at 18%. Both currently have $1000 in their emergency savings account. The minimum payment on both cards is $100 and each person has come up with a way to put aside and extra $100 a month. Individual A (Bob) wants to build a $2000 emergency fund to feel safer and have "peace of mind" before beginning to pay off the credit card. Individual B (Mary) decides to put all the money toward her credit card debt. Unfortunately 12 months after both of them begin their plan, there is an emergency that requires them each to pay $2000 - which one ends up paying off their credit card first?
<center><img src="http://www.savingadvice.com/images/blog/emergencyfund.jpg" alt="Emergency Fund"></center>
This is how the money situation evolves in each scenario:
Individual A (Bob):
Since Bob wants a $2000 emergency fund before paying off his credit card, he spends the first 10 months paying the minimum on the credit card and placing the other $100 into his emergency fund. This results in the credit card balance moving down to $4732.43 and him fully funding the $2000 emergency fund he wanted. For the next 2 months he pays $200 toward his credit card debt which brings the total down to $4472.47. Then an unexpected emergency occurs out of the blue costing $2000. Bob feels fortunate that he has the $2000 in savings to cover it and believes he made the right choice in building the emergency fund up for just such a situation. Since his emergency fund is now down to $0, he spends the next 20 months building the emergency fund back up to $2000 and only pays the $100 minimum toward the credit card. At the end of these 20 months the credit card balance has been reduced to $3711.40 and Bob once again has his $2000 emergency fund. He once again begins paying $200 toward the credit card debt and it takes another 22 months for Bob to completely pay off his credit card. In the end it takes a total of 54 months or 4.5 years to pay of the credit card plus he has $2000 in the bank. Bob ended up paying approximately $2800 in interest charges during this time.
Individual B (Mary)
Mary decides to bite the bullet and put all her effort into paying off the credit card debt without building an emergency fund first. She's a bit nervous because she knows she doesn't have any cash to pay for any emergency that might occur. She decides getting out of debt as quickly as possible is the most important thing and takes the $1000 emergency fund out of the savings account and places it toward the credit card debt. This brings down her credit card debt to $4000. For the next 12 months she pays the $200 a month toward the credit card debt which brings the total down to $2501.62. At this point there is an unexpected emergency that costs $2000 and since she doesn't have any money in the bank. Since there is no money in the bank, she is forced to place the cost on her credit card. This brings the credit card total all the way back up to $4501.62. She wonders if she made a mistake by not creating an emergency fund like Bob, but she continues to stick with her plan even with the setback. She continues to pay $200 a month toward the credit card debt and is able to pay off the credit card in full in 28 months. In the end it takes her 40 months (3.3 years). Mary then begins to place the $200 a month into a savings account for an emergency fund and comes out with an extra $800 ($2800) than Bob in her savings after 54 months. During this same period she pays approximately $2000 in interest to the credit card company.
If there is no emergency in the 12th month, the numbers are even larger in favor of Mary. Bob takes a total of 40 months (3.3 years) to pay off his credit card debt and has $2000 in the bank. Mary takes 24 months to pay off the credit card debt and after 40 months has $1200 more than Bob ($3200) in her emergency fund.
<center><img src="http://www.savingadvice.com/images/blog/credit-card9.jpg" alt="Credit Card as Emergency Fund"></center>
Both scenarios show that building an emergency fund before paying off credit card means paying more in interest to the credit card company. While it may give you a sense of "peace of mind" having money in the bank, as the above shows, it's a false sense that is actually costing you more money and extending the amount of time you'll remain in debt.
When you begin to pay down credit card debt, it frees up space under your credit card limit and this can be used as an "emergency fund." While the goal is to never use it, it is there if need be just as the money sitting in the savings account would be. This is using the credit card to your advantage instead of letting the credit card take advantage of you and that's ultimately the personal finance skill you want to develop to make the most of your money.
Whatever gets the job done best for YOU.
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