From a recent email from “Rick” –
If you had to begin your debt reduction journey today, would you immediately begin to attack your debts or would you first take the time to build up my cash reserves?
This is a great question, and one I’ve been asked several times. First, for the sake of this article, I’ll refer to my cash reserves as my emergency fund. Second, I’ll simply share my thoughts on the subject, and leave the financial advice to a qualified professional.
If I Were In Debt Today…
- I would create and begin to use a zero-based budget to manage our household finances.
- I would list each of my creditors and develop a debt reduction strategy.
- Before making any extra payments to my creditors, I would fund a small emergency fund, equal to $500 per person in our home. For our family, that would be $2500. (Four years ago, our youngest daughter had yet to be born, so our figure then was $2000.)
Just two weeks after we began our debt reduction journey, our son was hospitalized. It was during this time that my wife and I learned the value of the emergency fund. While insurance covered the cost of the hospitalization, there were a few associated expenses for which we were directly responsible. These were, obviously, unexpected expenses, so we used money from our emergency fund to pay for them. If we had not funded this small emergency fund, we would have been forced to use our credit cards, thus digging ourselves deeper into debt.
Please note, while we did stop making extra payments to our creditors, we continued to make minimum payments. It is crucial to make all minimum payments, in full, and on time, throughout the debt reduction process. If you are late with payments or you pay less than your minimums, you will be paying late fees and added interest. We hate fees.
There are several ways to calculate how much money one should have in an emergency fund, especially the beginning, smaller emergency fund. I arrived at the $500 per person amount by adding our automobile insurance per accident deductible to our family-wide health insurance deductible. I figured, optimistically or pessimistically, depending on your perspective, that we would have one health-related crisis and one automobile-related crisis during our debt reduction journey. In the end, we had two health-related inconveniences (neither really reached the level of a crisis) and nothing really went wrong with out automobiles. For our family, I calculated that a single crisis, whether it be health-related or automobile-related, would cost roughly $2000, so that’s the amount with which I went.
Throughout our debt reduction process, our small emergency fund balance fluctuated between $1000 and $2000. We had to tap into it on three different occasions, and while this slowed our debt reduction progress, just a bit, we also managed to avoid using our credit cards.
If I Had Just Paid Off My Debt Today…
- I would celebrate!
- I would continue to live on a budget.
- I would redirect the money which had been going towards debt reduction and use it to build my permanent emergency fund.
As soon as I made my last debt reduction payment, I began to build my permanent emergency fund. To the $2000 already in the small emergency fund, I quickly added an additional $18,000. For my family, $20,000 represents roughly six months’ worth of expenses. This money is untouchable, and is to be used only in the case of extreme, actual, real, I-cannot-believe-this-is-happening, emergencies.
If you just spend some time in the, you will see that I refer to my emergency fund by another name: non-retirement savings. I do this, simply to differentiate this money from any money that is held inside a retirement account. Not to split hairs, but there is a slight difference between non-retirement savings and the emergency fund, in that the former can be used for any expense (budgeted or non-budgeted) and the latter is to be used specifically for emergencies.
Again, the $20,000 amount is specific to my family and our current situation. For some families, this number might be $10,000. For others, it might be $50,000. In fact, I actually have a poll open, asking readers the question – How Much Is 6 Months Worth Of Expenses? If you haven’t done so, click over and vote. As of today, more than 1100 votes have been cast, and the most popular amount is somewhere between $12,000 and $20,000.
To summarize –
Before and during debt reduction, I would maintain a small emergency fund, based on the size of my family.
After debt reduction, I would increase my emergency fund to six (or more) months’ worth of expenses, again tailored to my family size.
The debt that I am referring to in this article is non-mortgage debt.
Finally, if I had children with special needs or a family member with certain fixed medical expenses, I would consider a larger emergency fund, both during and after debt reduction.
These are my thoughts. What would you say to “Rick” about debt reduction and the emergency fund?