Debt Reduction, Emergency Fund

Debt Reduction And The Emergency Fund

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…

  1. I would create and begin to use a zero-based budget to manage our household finances.
  2. I would list each of my creditors and develop a debt reduction strategy.
  3. 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…

  1. I would celebrate!
  2. I would continue to live on a budget.
  3. 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 archives, 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?

10 thoughts on “Debt Reduction And The Emergency Fund

  1. Well i recently became debt free and wondered about the same thing in terms of savings.

    But in my situation it wasn’t really needed to have savings because my expenses were very little and I lived at home.

    Also, I looked at it as if money saved does not give me a return while at the same time i am getting charged interest, so it made sense to dump as much as i can towards debt.

    Now the situation is probably different when you have dependents or even live on your own because at that point it would make sense to have savings.

  2. I’d like to add an extra step, maybe so obvious nobody mentions it.

    After you realise you want to get out of debt and start saving, and before you start your emergency fund, you need to make sure you pay everything on time. That you’re not behind on any bills.

    Not everyone needs to take this step, but if you do, it’s very important to start with it (after you created your budget, or maybe during). You’ll never catch up if you keep falling behind in paying bills and having to pay late fees (think of that money!)

    I’d definitely start with a small emergency fund too. It’s good for morale to not have to dip into your debt (and increase it / undo all the payments you’ve made so far) if an emergency occurs.

  3. I recently blogged about paying off our Saab, our last consumer debt. Now all we have are student loans. Lots of ’em.

    My question to you would be, would you include your loans as part of the 6-months worth of expenses since they can be deferred if you are unemployed?

    I’m interested in what people think.

  4. Great Post.. I belive that the first step in anyones financial planning should be build an emergency fund. Offcourse if you have debt pay it off and then do it. One must have anything between 6 to 8 months of expenses as your emergency fund. Invest it in near liquid instruments like FD, liquid funds etc so that its accessible when you actually need it. Also most important thing is not to use it for anything other than real EMERGENCY…

  5. Good post. I think there is a huge difference in financial attitude before and after debt. I classify everything while in debt as defensive… (ie consolidated a pay down debt, get a budget etc…). After paying debt down – then it’s okay to go offensive (ie save). And counter-intuitively – judicious use of credit is important here to. Eg.

  6. $20k is six months of expenses for your entire family? So you spend a total of $40k a year? That’s amazing, really low. Where do you live that you have such a low cost of living for a family of five?

  7. @Hannah – The 20K would replace one of our salaries for 6 months… not both…
    That being said, should we both lose our jobs, we could get rid of all “wants” and simply live on a bare bones budget of just “needs”…

  8. Ok, that makes sense! Phew, I was wondering how my budget got so out of control! In that case, our numbers are roughly similar. We have enough saved to replace both of our salaries for four months. That said, we consider our Emergency Fund and our Non-Retirement Savings to be one and the same. I hope never to go below 3 months (of both our salaries) in the emergency fund, and ideally I’d like a totally separate fund for other savings goals (i.e. a house someday, maybe a car someday). But in reality, this is just our savings, period.

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