We have all heard the scary statistics. Around half of all Americans could not pay for a $400 expense because they have no emergency fund. I would venture to guess a lot of these people currently have debt on their hands, and are doing what they can to pay it off. In fact, 80% of people have some kind of debt. If an emergency expense arose, they would dip back in the debt pool to pay for it. It can feel like it creates an endless cycle that traps you into paying down debt forever.
If you are on a boat and it starts to spring a leak, you don’t just take it to dry land, let the water drain and take it back out to the water. You fix the leak so the boat doesn’t continue to take on water every time you put it in the water. It would create and endless cycle of draining the boat only to have it fill back up. If the leak got bigger or an unexpected wave hit, then the boat would end up sinking altogether.
This is what can happen if you don’t focus on building an emergency fund while also paying down your debt. While debt is a problem on its own, the real issue was not having enough money to pay for expenses. You can control the self-inflicted spending, but unexpected bills will need to be taken care of with an emergency fund. By doing this, you can greatly decrease the likelihood of taking on more debt while you pay off existing liabilities.
Pay Debt Minimums to Build up Emergency Fund
When I was younger, I had 6 monthly debt payments that I kept up with. I had a car loan, a credit card bill, and 4 student loans. Every month the payments and accrued interest were sent off. I, like most people, wanted these debts paid off as soon as possible. I threw what little extra money I had at them. Usually it ended up to be around $10-$20 extra every month on each loan. I figured even if it was a little bit, they would all be paid off sooner than if I just paid the minimum.
I had no savings account to speak of after buying my restaurant and was grinding it out to make that business a success. Any emergency expense would cause me to reach to my credit card to pay. This would add another payment, more interest, and longer time to payoff, even with me paying extra!
I should have built my emergency fund back up instead. By taking the extra $120 a month and putting it away, I would have over $1400 in a year saved. I quickly understood why my dad always kept a ‘hidey hole’ of money for emergencies. It was to help from having to pay small emergencies with credit.
If you are able to make more than minimum payments, make sure your emergency fund is taken care of first. It may not be a full 6 months of salary, but having a margin of safety can plug the debt leak in your finances.
If you are just barely making it with minimum debt payments, then you must make changes to your budget. It goes back to the old adage of making more money or spending less. From there, start the emergency fund build.
Don’t Spread your Extra Payments Around
After your emergency fund is built, start paying down those debts as fast as possible. Do not do my method of spraying your extra payments all around. Have a plan to pay down one at a time, using the new-found cash flow to pay off other debts. Let’s examine this with my previous situation.
I called to ask what my expected payoff date was on my car loan after making extra payments for well over a year. I would pay around $20 extra per month. My car payment minimum was $323 a month. At $20 extra a month, I wasn’t even paying a full extra payment in a year! After the lady told me my payoff was just over one month ahead of schedule, I was pretty discouraged!
Here is a calculation I did on calcxml.com. The first image shows what paying $20 extra a month does to a 6 year, $20,000, 3% loan vs paying $120 extra.
By focusing on one loan at a time, you are able to get it finished much quicker, allowing you to use even more money to attack the next loan. It also allows you to have more cash flow, which can in turn help pay for a bigger emergency if needed, further helping you avoid future debt.
In essence, this gives you a stronger ‘boat’ to protect against debt leaks.
Debt is a pain in the ass, and a huge inhibitor to achieving many financial goals. It is tough to retire early while managing a six-figure debt load. That is why my wife and I have started tackling our debt aggressively, creating a very specific plan to paying it off as soon as we can. This had led to less spending and trying to create more income.
We have been able to build a healthy emergency fund to avoid a ‘debt leak’. It gives us a margin of safety, and an ability to take all extra money and use it for paying down student loans. That is why having an emergency plan is such a wise decision. You make sure you actually fix the problem of not having cash on hand. Changing your spending habit is the other way to make sure you have cash available for debts and emergencies.
Thanks as always for reading! Do you agree with building an emergency fund before making extra debt payments? Do you attack one loan at a time or multiple?