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    Paying Off Credit Card Debt vs Building An Emergency Fund

    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.

    #2
    Re: Paying Off Credit Card Debt vs Building An Emergency Fund

    While this is true in theory and very interesting actually, I have to put in the other factor that is being completely ignored. What if you don't have enough on the card to allow for the emergency? This is also a scenario that says they both already have $1000. But if like most of us you don't, what next? Lets say that the card is $2000. But you have maxed it out. You go ahead and build the emergency fund to $2000 while paying the min. Then you have to use your emergency fund. At least then you have an option to not further build debt as well as using the emergency. (based on that the card is not enough to cover the emergency) While I agree that yours would work on a high credit level I don't think that it does if you have a low credit level card. Especially if the emergency isn't nice enough to wait until you have the card paid off, which it usually doesn't. Or even if the card is not worth that much. Do you think that would change the scenario?

    Comment


      #3
      Re: Paying Off Credit Card Debt vs Building An Emergency Fund

      Originally posted by cicy33
      While this is true in theory and very interesting actually, I have to put in the other factor that is being completely ignored. What if you don't have enough on the card to allow for the emergency? This is also a scenario that says they both already have $1000. But if like most of us you don't, what next? Lets say that the card is $2000. But you have maxed it out. You go ahead and build the emergency fund to $2000 while paying the min. Then you have to use your emergency fund. At least then you have an option to not further build debt as well as using the emergency. (based on that the card is not enough to cover the emergency) While I agree that yours would work on a high credit level I don't think that it does if you have a low credit level card. Especially if the emergency isn't nice enough to wait until you have the card paid off, which it usually doesn't. Or even if the card is not worth that much. Do you think that would change the scenario?
      It doesn't change the scenerio. If your credit card is maxed out and you have no savings and an emergency happens, you have to come up with a new plan to pay in either case.

      If your credit cards are maxed and you put $100 into savings or $100 toward credit card above the minimum, it frees up that amount on your credit card in case of an emergency. It's the same either way.

      Comment


        #4
        Re: Paying Off Credit Card Debt vs Building An Emergency Fund

        This has always been my thought. We started aggressively paying off the cc and said "savings can wait". It was a gamble and when DH lost his job, we did have to put more debt on the cc's (again), but I think we came out better in the long run.

        Plus, the more we paid, the higher they raised our credit limits. We ended up having to tell them that was enough credit limit - it was up to something like $60k (and we made about $32k/year at the time). I figured there would be no emergency that we couldn't cover with a $60k credit limit.

        Comment


          #5
          Re: Paying Off Credit Card Debt vs Building An Emergency Fund

          I agree that it makes sense to put available money toward paying off debt instead of trying to build an emergency fund. There is one mistake that I made when I first started doing this though--I mistook emergency savings for "semi" annual expenses.

          For over a year I applied almost all of my left over money toward my debt each month. Unfortunately I hadn't thought about the registration/taxes due on my car or my bi-annual car insurance or my annual renter's insurance. When these came up, they went on the card that I had been paying off. Luckily, I realized that this was not the best thing for me to do--it was similar to putting all of my bills on my credit card and just paying with what I had.

          So now I do have a savings account that I put money into, but this is for the irregular expenses that come up, not for an emergency savings.

          I just wanted to point this out in case there is anyone else out there who might be thinking the same way that I had been.

          Comment


            #6
            Re: Paying Off Credit Card Debt vs Building An Emergency Fund

            I bought a house the second year I was married. When my property taxes came due, they were $300 and I did not have the money, that was more than a whole month's pay. That is when I came up with a new catagory for my budget envelopes. I added up all my car insurances, house insurance and property taxes and divide them by 50. That is what I put away each week and I let it accumulate in my checking account snd pay when due. It works for us! ( I keep try of it with a memo in the check book cause all the car insurances (we have 4) come due at different times.)

            Comment


              #7
              Re: Paying Off Credit Card Debt vs Building An Emergency Fund

              I had the same problem with those semi annual and annual insurance premiums. Most insurance companies will let you pay monthly but it costs so much more it isn't worth it. I finally found an insurance company (State Farm) that will allow me to pay monthly and enjoy the same rate as if I paid every 6 months. Well, it costs me $1 a month to pay this way, but it is well worth the $1 to have a regular amount I can budget for. I have my car and renter's insurance through them now, and it is one monthly payment. State Farm has a great web site for getting quotes too, and they break it down by monthly and semi annual amounts. Best of all, they had really good rates - better than Progressive.

              Comment


                #8
                Re: Paying Off Credit Card Debt vs Building An Emergency Fund

                I have been with state farm for 40 years and they have been a good company to me.

                Comment


                  #9
                  Re: Paying Off Credit Card Debt vs Building An Emergency Fund

                  I dunno, I think I'd rather have cash for emergencies rather than let debt bail me out. Emergencies happen and they always will. Why not have both? And emergency fund AND pay down that credit card??

                  Comment


                    #10
                    Re: Paying Off Credit Card Debt vs Building An Emergency Fund

                    I have had this uh debate elsewhere from those who are adamant about starting out with at least a tiny emergency fund to start with.

                    However, this is not what I did, nor what I personally agree with. Believe it or not, but I did the same thing that was suggested in this article, which was to pay off the credit cards first, and hanging on to one as an ad hoc emergency fund.

                    Hmm, I could've sworn I've already commented about this elsewhere in this forum. Anyways, I still firmly believe that paying off credit cards is the best way to go, but I also understand if doing it the other way will make other people feel better and motivate them to get out of debt.

                    Whatever floats your boat.

                    Comment


                      #11
                      Re: Paying Off Credit Card Debt vs Building An Emergency Fund

                      I agree with the original poster. Everything he said makes sense and I've always felt that paying off debt should be your first priority. Although I've never been in debt myself, I guess I can't speak from experience. But mathematically it just makes sense.

                      The only thing I can think of where you might run into trouble if you don't have an emergency fund is for paying rent for an apartment. There are a lot of apartment owners that do not accept credit cards for payment so if you had an emergency you wouldn't be able to rely on your credit cards to pay your rent.

                      Comment


                        #12
                        Re: Paying Off Credit Card Debt vs Building An Emergency Fund

                        This has been previously discussed but remember people are new and don't always see the old posts. That said, I am still a firm believer in having some savings to cover bills that you are going to have if something should happen. Especially if you have no way to cover those bills. For example, what if you are paying old debt and you no longer have access to the card then what will you do? I think that you should apply some to debt and some to savings. Perhaps after a while, like a few months, if you have some savings built take part of it and pay down the debt. But I personally want a little cushion. Otherwise you are simply repeating the cycle of debt. however, strictly my opinion.

                        Comment


                          #13
                          Re: Paying Off Credit Card Debt vs Building An Emergency Fund

                          Whatever gets the job done best for YOU in your situation, right? Some people need emotional fallbacks not just logical numbers-- others can bite the bullet with just hard logic and tight bootstraps! Whatever gets the job done best for YOU.

                          Comment


                            #14
                            Re: Paying Off Credit Card Debt vs Building An Emergency Fund

                            Absolutely! each to his own. We have decided to do away with credit cards personally and if we don't try to save some we would be in such trouble cuz we don't have a card to fall back on

                            Comment


                              #15
                              Re: Paying Off Credit Card Debt vs Building An Emergency Fund

                              When we were paying off debt, we did so without too much knowledge. I agree that by using the EF to pay off the debt that you are actually saving in a way because it frees up the same amount in your credit card if you need it. My other pet peeve is that your savings account is also earning interest. You not only are paying the interest on the debt, but you are being taxed at 15% or whatever your income is just for a peace of mind that you already will have by freeing up some of your credit. Most of us forgot that credit used to be used as an emergency not as it is today. I would also suggest that people keep cash on hand at home for many reasons. For one, there are certain things that you can't put on a crefit card. One could be lunch for the kids, a birthday card, children's photos from school. And the last time I checked, you can't pay your car insurance or property taxes with a credit card. Anyway, a small cushion at home would be good and it could be reimbursed at the end of the month.

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