I was reading a well written post from Money Ning about emergency funds. He was recommending an emergency fund over using the money to pay down debt. I totally agreed with him, but as I read the article, I thought of it in a different perspective, and that my readers might agree or consider as food for thought.
The Biggest Value In Emergency Funds
Where it fell into place for me was when I started thinking about it in terms of where you would get the most bang for your buck.
Consider the following examples:
Credit Cards, Student Loan Debt, and an Auto Loan
The two most standard types of debt where I would think the person questioning 'emergency fund' vs. ‘debt' would be student loan debt and credit card debt, and throw in a car payment as well. Say you have someone with $40,000 in debt, and they've decided to tackle that debt and try to become debt free.
First, celebrate that. If you've made that pledge, then good for you!
Second, let's look at what would happen if you had $1,000 and used it to attack your debt.
In the example above, your $1,000 would pay off 2.5% of your outstanding balance.
This is nothing to sneeze at and probably represents a bigger chunk than would normally be paid with minimum payments. There's nothing wrong with that, but is it really enough bang for your buck.
Which leads us to the second option
Should I Start an Emergency Fund
If you have that $1,000 and stick it in the bank, you are obviously set to pay against an unexpected expense, at least for the first grand.
This is great. Let's think of a couple of examples of how this would play out:
- You get in a car accident. Repairs are $6,000, but your insurance picks up everything after your deductible, which is $1,000.
- You get sick or injured and have out of pocket health care costs of $1,500.
- You get laid off from work for two months. Your severance and unemployment can cover all of your expenses except for your $400 per month car payment, meaning you'd be short $800.
In each of those cases, using your $1,000 emergency fund would be completely appropriate. These are all emergencies and precisely the types of situations where you'd use an emergency fund.
But, what kind of bang for the buck are you getting?
- In your car accident, your emergency fund covers your entire deductible, so your emergency fund gives you 100% bang for the buck.
- If you get sick or injured and have your bill, your emergency fund covers two-thirds, giving you a 67% bang for your buck.
- In the event of your layoff, your shortfall works out to being fully funded, again giving you 100% bang for the buck, with the added bonus of having $200 left over that you don't have to replenish once you get back to work.
In each of those cases, your bang for the buck far exceeds the 2.5% bang for the buck that you'd be getting by paying off debt.
The Math Works Almost All The Time
Obviously each person has different debt numbers and each emergency will offer different numbers, but the fact of the matter is that unless the cost of your emergency comes in at a greater cost than your outstanding debt, you'll get greater bang for the buck by starting an emergency fund every single time.
Important Considerations For An Emergency Fund
Don't take this too far. Some people might ask why stop at $1,000 and build an even bigger emergency fund. I think $1,000 is appropriate as it's going to likely cover over half the costs of most short term emergencies. Yes, there are situations where that might not be the case, but the goal of an emergency fund is not to protect you against every worst case scenario, but it's designed to put you in front of a majority of situations which could provide short term financial catastrophe.
As you get lower in debt, you might bulk up your emergency fund in small increments, or you might also do so if emergencies might provide bigger risk, for example if you start a family.
In either case, the details in how you approach setting up and maintaining your emergency fund will vary, but the one constant I would recommend is that you should put a small emergency fund in place before paying extra on debt no matter what.