One of the most contentious things we’ll say in our series of posts over the next year is that we believe it’s more important to set up an emergency fund than pay off outstanding debt. Our thoughts are nothing new and this discussion has been had many times before, but it is important that you understand all sides to the debate so you can decide what works best for you.
You’ve read about the importance of establishing an emergency fund and you know some clever places where you could build your own. We even went so far as to tell you how it’ll all be taxed. But there might be a small voice inside your head, saying…
“But hang on”, I pay a monthly instalment to the bank every month for my car and my house. I may not be a finance wiz, but I know enough to appreciate that I’m being charged interest on that. Should I not be paying these debts off first?”
You run that idea by your colleague who works in Accounting, who further adds…
Yes, and to think that you’re paying interest at ‘prime’ on your car finance, so by paying off your car earlier you’re earning 9.5%. You’ll never earn that much on cash, so it makes sense.
At this point you could be ready to unlike us on Facebook for spewing lies.
As we will stress time and time again here at WellSpent; there are very few perfect ways of doing things when it comes to personal finance. Most of the time it’s about coming up with a good plan that works for you and not about coming up with the ‘best’ solution.
Personal finance is about so much more than numbers. There are plenty of softer issues like our relationship with money and what money means to us. Money might give you a great sense of security in which case you’d likely be slightly more risk averse and value certainty in your life, whereas for someone else, taking every opportunity to maximize a gain might be the right way forward. Neither is wrong, as who’s to say what money means to you.
So on that note, let’s jump right in to the nitty gritty
Building an Emergency Fund VS paying down Debt.
You would have learnt by now that the going interest rates on cash are not exactly stellar, and there is a real temptation to consider doing something else with your emergency fund money – something that might offer you the chance of a better return.
One commonly discussed alternative, as was noted by your friend from Accounting, was to use what money you would have saved and rather pay down some debt, say on your car finance or your house bond. The interest you save is the return you effectively guarantee yourself. By paying off vehicle finance early, you’ll be paying less interest over the life of the finance contract. By paying less interest over time, it’ll mean more money in your pocket, which is what you’ve effectively earned. While you would not have ‘received’ any interest, your cash balance will be bigger, so the effect is the same.
The problem with this is that you still don’t have any cash stashed away for a rainy day. You won’t be able to draw down from your vehicle finance if you needed the money in an emergency.
If you had chosen to rather put money into your bond, the economics are similar, but the issue still remains in that you don’t have your rainy day money at hand should you need to deal with a financial emergency. If you need reminding as to why we are not in favour of using your access bond to house your emergency fund, then take a quick refresher.
This fork in the path that you have to decide on is a common one, as we advocate that everyone maintain an emergency fund and the chances are that everyone has some debt on their balance sheet, in vehicle finance, a credit card balance or store credit.
It’s up to you.
We are not disputing that from a pure mathematical point of view, over the life of the debt you will save more by paying down your debt early, however the issue remains that you won’t have access to cash if you need it. If personal finance was all about rationale behaviour and people doing things that made the most ‘sense’ chances are we wouldn’t need personal finance websites like this one in the first place.
Good news! There’s a middle ground.
If you battle between doing what makes mathematical sense and having that peace of mind that having a wad of cash saved away gives you, then potentially consider saving a third of your desired emergency fund balance, then tackle some debt, and then carry on doing what works for you. Save some more, pay down some more. Just make sure that you end up with your emergency fund and continue to tackle debt.
Coming up: dealing with debt.
We’ll get around to getting on top of your debt in our next article. Once you’ve had a read, you might have a better idea in your mind as to what works best for you.