Best Investment for 2009: Use your Emergency Fund to pay off your debt

By Mike

Just by writing this title, I already know that people won’t agree with this strategy. How can you tell people to get rid of their emergency fund while we are in one of the most important recessions ever? So please, keep reading until the end of the post, I promise to make sense ;-)

First things first, I am a big fan of the “pay yourself first“¬Ě technique when it comes to personal finance. If you consider yourself as a priority creditor, you will put money aside for your personal finance and then, live off the rest. Many of my clients are asking the same question with regards to extra money: Should I pay down my debt or invest the difference?

Some people will build a 6 month emergency fund, others will invest the money in a stock portfolio and the rest will pay down their debt. But in many cases, the best investment would be to pay down their debt. And if you have an emergency fund, you should use it to pay off any existing debt such as your credit cards or create additional room on your home equity line of credit.

Savings accounts don’t offer much interest

When I advise my clients on what to do with their money, we find money market funds and saving accounts offering less than a 2% yield. So, here you are technically losing money if you put it aside in an emergency fund. How come? The answer comes in 2 words: taxes & inflation.

Historical inflation is over 2% and most economists expect it to keep an average pace of 2%. So, if you are marking 1.50% in your savings account and you pay 25% in taxes; you are left with a real return of 1.125%. Therefore, if the inflation is 2%, you will be lose almost 1% of your purchasing power per year. You don’t need to read an investment guide to understand that this is not the best way to increase your net worth, right?

On the other hand, credit card interest rates are much higher

Unless you were able to get a zero percent balance transfer credit card, you are probably paying around 10% on your credit card (if not higher). Therefore, you could use the money in your emergency fund (making 1.5%) and pay off debt at 10%. This method helps you  multiply your investment yield by more than 6 times when compared to a money market fund.

We’re in a recession, what happens if I lose my job and no longer have an emergency fund?

I guess this is the part I like the most about personal finance; there are no black and white answers! A few years ago, I would have answered back: take your whole emergency fund and pay off your debt. If you need money because you have lost your job, just use your line of credit for the time being.

However, since the recent credit crunch, we have seen financial institutions using the fine print to their advantage in order to cut credit limits to millions of upstanding individuals. The banks were so panicked that they simply looked to decrease their exposure to risk.

So I am not saying that everyone should cash in his entire emergency fund.

However, I think that if you have 3 months emergency funds (everybody should be looking to cover 3 to 6 months of income according to financial planning guidelines), you may use a few weeks’ or a month’s worth of income to pay off a few credit cards.

Once this is done, you can use the snowball effect to reimburse your emergency fund. Therefore, you will save a great deal of money in interest and you won’t be exposed to big risk.

Using the snowball (taking the money used to pay off one debt in full and add it to make a bigger payment on the following one) in order to reimburse your emergency fund will be a great way to make sure you replace your emergency fund to the level it was a few months earlier.

Author: Mike.

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9 Responses (including trackbacks) to “Best Investment for 2009: Use your Emergency Fund to pay off your debt”

  1. James Says:

    I agree with you. Debt essentially makes us a slave to the one who provides the loan. Better reimburse your credit card bills and debt. Need to be disciplined and invest wisely once that done but we must always hope and firmly rely on God’s goodness and mercy and love to see us through the difficult times in life.

  2. ABCs of Investing Says:

    I agree – if you have high interest debt then your emergency fund becomes very expensive to have. Nothing wrong with a small one (ie $2k) but any more than that and you are throwing money away.

    On the other hand if your debts have lower interest rates, say 7% or less then keeping money in an EF is not so expensive and it’s ok to have a bit more.

  3. Craig Says:

    It’s interesting this debate would come up. Some would ensure never to spend your emergency fund, and others would say an emergency fund should not even be started if you already have debt. If it is bad debt like CC debt, then you definitely should use the fund towards it.

  4. Bret @ Hope to Prosper Says:

    Having been laid off twice in the last decade, I can definitely say there is no substitute for cash, when times are tough. If you have an emergency fund, I recommend you hold onto it. And, if you have debt, make a plan to pay it off. Because, once your cash is gone, you can’t get it back when you need it.

  5. eemusings Says:

    I’d never be comfortable totally depleting my EF. I definitely think there are great arguments for using it to pay down debt, but you always need a cash reserve – as Bret above says, once your cash is gone, it’s gone.