16 May 2009

Is an Emergency Fund right for me?

I am a firm believer in an emergency fund.  I tell others about the benefits and why they need one.  I have it as part of my long term plan.  I just don’t have a fund right now.  Lazy Man and Money is Glad he has an emergency fund.  I am glad i don’t have a fund right now.  Dave Ramsey advocates having a $1000 emergency fund first.  My wife and i are working on our credit card debt first.  So why don’t we follow this advice yet?

The costs of an emergency fund

The first cost of an emergency fund is the fund itself.  If you have a $1000 emergency fund your first cost is $1000.  If you have credit card debt putting $1000 in to a savings account is no different than taking a $1000 loan against your credit card.  This $1000 is keeping me in debt longer.  It is $1000 not going to pay down my debt.  On our plan this is now 2 1/2 months longer with credit card debt. Had we started when we first began working to become debt free this was almost 6 months longer.

When paying down debts you pay down the lowest balance or the highest interest rate.  We chose the highest interest rate.  An emergency fund equates to a loan of $1000 at the highest interest rate.  The rate on this emergency fund loan drops each time you pay off your highest interest debt.  Each month i don’t use that $1000 toward debt lengthens the time i will be in debt.

When an emergency hits what happens?  There is no difference to my finances with or without this emergency fund.  If i have a $500 car repair hit and don’t have an emergency fund this bill gets added to my 8.24% interest rate card.  If i pull this out of my emergency fund i add $500 back to the fund before paying extra on my cards again.  This leaves the credit card with a $500 higher balance until my emergency fund is replenished.  Either way i pay the interest on the $500 on the credit card bill. Six in one hand, half dozen the other.

Financial Insurance

Having an emergency fund is an insurance policy against trouble.  It protects you from paying interest on these emergencies.  Until you are out of high interest debt the costs are the basically same.  Insurance is a gamble against yourself.  Life insurance is a gamble that you will die.  Car insurance is a gamble that you will be in an accident.  Health insurance is a gamble that you will have health problems.

When to start the emergency fund

Hopefully never.  Wait, never?  With some advance planning you can have an ING Savings fund for health costs, car repairs, lost job, etc along side your vacation fund.  Since most people don’t want to plan that much in advance they lump all of these into one “emergency fund”.  Even i don’t want to plan that much so i too will opt for the emergency fund.  If you were going to have these separate funds you don’t start until your debt has been paid down.  Using a lump “emergency” fund then i suggest starting at this same point.  Don’t take a loan against yourself.

 

What do you think?  When do you start your emergency fund?

2 comments:

  1. We followed DR's advice when we began our "get out of debt" journey... A few reasons that I prefer that route:

    1. It's a mental thing. It's very discouraging to incur more debt in the midst of scrambling to pay it off. We haven't borrowed one penny more since we began paying off debt three years ago. Last year, we had so many emergencies we didn't pay much off, but we didn't go backward either!

    2. It's a good habit. Keeping money set aside for future use has been a goal but never a reality. Keeping $1000 set aside for emergencies (not vacation or routine health care) has helped us develop the habit.

    3. My husband, our sole earner, has been laid off this month. I feel much more prepared having some small savings over owing $1000 less to one of our debts. We will not have to borrow money before being employed again. Without our emergency fund', we'd have no cushion before needing to borrow.

    That being said, we're also paying of the smallest to the largest. We've decided our primary goal here isn't saving the small difference in interest. Our goal is to permanently change our behavior and I think that requires a different approach!

    Looking forward to reading your other blog posts now!

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  2. Emergency funds are for everyone! But if you have debts, I think it would be better to set your expectations low first. You have a point in saying that it can keep you in debt longer, so start saving an amount that you wouldn't notice it was already taken away from your income.

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