It starts innocently enough; we see others who seem to be doing well and naturally want that for ourselves, too. And the sooner, the better. Or, maybe an opportunity or unanticipated expense comes up that needs to be addressed. How we respond depends in part on where we stand with debt and emergency funds.
So, we borrow a little to make it happen. And, who knows, maybe others are borrowing too since we live in a consumer-driven economy fueled by debt. U.S. household debt was $13.5 trillion at the end of 2018, as reported by the Federal Reserve Bank of N.Y.
We borrow because we spend more than we earn. There is no way around that. We are predisposed to do what others do, follow the crowd, especially if it seems to improve things.
If others don’t wait until they save up enough, then why should we? Isn’t it just spending a little faster than we earn?
It might start off that way, with the idea of paying later, but many do it again and again. It goes from spending a little faster than we earn to the slippery slope of spending more than we make if it’s repeated.
It’s a cycle that’s not sustainable. But how can we stop it?
Debt and Emergency Funds
In The SMART Personal Financial Plan, we looked at options to make a Personal Financial Plan SMART (Specific, Measurable, Attainable, Realistic and Time-based) and touched on debt reduction.
This is the first in a series of three articles on putting first things first. Debt must be under control and provisions made for an emergency before we invest to grow our wealth.
We start here with debt and emergency funds. In the next section, we determine where your debt stands in the eyes of others and discuss prudent and bad types of debt. And in the final article, we give you the tools to implement a fix for whatever isn’t right.
“You can’t build wealth or grow a legacy with debt. Holding onto debt is setting up future generations to repeat those same mistakes. But making smart financial choices provides an example for your children—and their children—to live by.”
– Dave Ramsey
But first, a short story.
The Consumer and the Credit Card
This is the story of a consumer who one day discovers in the mail a glittering credit card pre-approved for thousands of dollars. He thinks this must be some kind of trick. But as he starts to throw the credit card aside, he has second thoughts and takes it to a store instead.
The credit card is like cash! The consumer can’t believe his good fortune. He becomes even more amazed the following day when he buys some long-wanted sports equipment and furniture. Day after day, he awakens to rush to the stores and use the credit card. He feels fabulously wealthy, and his friends think he is, too.
He no longer has to save and wait for the discretionary things he wants—he can purchase them along with the things he needs. But with his increasing fortune comes greed, impatience, and (of course) more spending.
But one day he opens the mail to find a credit card bill with a high balance and an interest charge. There is no more credit available—and now there is no way to get more cash. Worse, the consumer has already spent the future earnings that produced the credit card offer in the first place.
If this story sounds a lot like “The Goose and the Golden Egg,” that’s because it’s very similar. The consumer (the goose) is working for the lender, so his earnings (the golden eggs) are no longer his to spend.
Future earnings now belong to the lender with interest added for good measure.
Debt is the Problem, Not You
People find themselves in debt for many reasons. Maybe to pay for higher education, a medical emergency, or getting on that slippery slope of overspending earnings.
How you got there really doesn’t matter anymore. Think of it as your current circumstance and starting point. What matters now is your responses to the opportunities or challenges you face here and now.
It’s easy to get caught up in your position and ignore your power to change it. Let’s get started.
If you are in debt, the first steps to creating wealth are simple and surprisingly rewarding:
- Make provisions for emergency funds
- Pay off high-interest debt
We need to be prepared for the things that can go wrong because they will go wrong. So, having money available to cover an emergency is essential.
An emergency can lead to unpaid bills that harm your credit or redirect funds from other uses. And, that can negatively impact those other uses. The idea of avoiding costly credit card charges for emergencies is correct, if possible, but that’s not always the case.
Remember, we are talking about emergencies, unusual events that should be rare. You can also think of the emergency fund as an insurance policy for emergencies. And like any insurance policy, you want to minimize the cost of the coverage.
The amount of an emergency fund needed is very dependent on your situation. Just $500 – $1000 will cover some emergencies, like unexpected automobile repair.
Some recommend the more debt you have, the more emergency funds needed to cover minimum debt payments. Often three, six, or twelve months of earnings are recommended for emergencies during extended things like a job loss, illness, etc.
Credit Card Debt
According to a recent American Household Credit Card Debt Study, the average U.S. household credit card debt in 2018 was $15,561.
Ideally, you would pay off your credit card balance each month to avoid interest charges, but only 52% of credit card users actually do.
The remaining 48% of households have an estimated $6,929 in balances carried from month to month, with slightly less than half only paying the minimum amount due.
For those that do carry credit card debt from month to month (revolving credit), it’s a heavy burden with an annual percentage interest rate (APR) between 17% and 24%, according to the U.S. News database.
Let’s Get Real
The median household income is about $60,000 per year. Even the lower three month emergency fund recommendation would be roughly $12,000 in after-tax earnings for that household ($5,000/month X 3 = $15,000 X 80% take home = $12,000).
Is it realistic to think people struggling with credit card debt can also accumulate $12,000 in savings while paying the debt? If they can save that amount, should they?
Using low-interest savings accounts for emergency funds has a high opportunity cost. Why earn maybe 1% interest in savings while paying 17% to 24% interest charges on outstanding credit card balances?
A Smarter Emergency Fund Strategy
A smarter strategy is to pay down the high-cost credit card balances first. That also frees up borrowing capacity on your credit card to be used if and only when an emergency actually occurs.
I’m advocating you consider debt and emergency funds together and make the choices that skew the outcomes in your favor, not the banks’ and credit card companies’.
Don’t let the financial companies pay you 1% to use your money in a savings account so you can pay them 17% – 24% to lend it back to you!
There is no doubt you have to pay interest on the credit card balances if you carry them from month to month. And, preparation for an emergency is essential if one does occur but we don’t know if one will.
Pay off the credit card balance first, and then if an emergency occurs use the remaining borrowing capacity on the card to fund the crisis. Don’t pay 17-24% interest in case there is an emergency, only pay that interest if there actually is an emergency.
If you don’t carry credit card debt from month to month, great, you are not paying the interest rate penalty on the balance. You can still pay down your credit card balance to free up more capacity for an emergency fund if needed.
This would enable you to place money into higher-return investments rather than savings collecting low-interest rates.
Skew the outcome in your favor and lower the cost of your insurance policy for emergencies.
Open and Honest Communication
Whether you’re struggling or have concerns, don’t keep those thoughts to yourself. Have an open and honest conversation with loved ones and trusted friends about money issues.
Tell them what you’re trying to do. Chances are, they’ll be glad to hear you are proactively working through money matters. They may offer advice, or may even be able to step in and help you in an emergency situation if one arises. You can offer to help them as well.
And don’t forget to compare ideas with trusted friends or colleagues. Get creative and talk with family and friends about helping each other with emergency personal loans should an emergency ever occur.
What We Learned Today
- You need emergency funds for things that might go wrong, and they will.
- Optimize debt and emergency funds by considering them together.
- Credit card borrowing capacity is often an attractive alternative to cash for emergencies.
- Open up communications on money matters with family and friends. They can be great sources of ideas and help if and when needed.
- Only you can think through your particular situation, the risks involved, and the best outcomes.
- Preparation for emergencies is essential even though they are rare occurrences.
In the next article “Debt Part 2 – Measure Your Debt-to-Income Ratio” we show you how to determine where you stand in the eyes of others and discuss prudent and bad types of debt.