use emergency fund to wipe out CC debt?

[zanyzach37]

hi guys,

i'm a 26 year old recent graduate (2.5 years ago) from outside of boston, MA. i've been saving aggressively for the past 6 months to build up an emergency fund that currently stands at around $4,500. i've also got $6,700 in credit card debt, which was accrued from business purchases that i made earlier in 2008.

i'm not putting any money onto the credit cards anymore and i've actually paid the CC debt down $800 since november, but i was thinking that once i hit $6,700 in my emergency fund, that i'd pay off my credit card debt fully. it keeps me up at night and i don't feel good about it at all.

about half of my income comes from a stable job that i get healthcare and a 403(b) plan from, and the other half comes from freelance work, which has been somewhat unstable lately (i.e. january was really slow but february, only 4 days in, has already netted me twice as much income as january). most of the money i contribute to savings comes from my freelance income; i need the money from my regular job to live and cover rent/utilities. i've paid off all my student loan debt already (got scholarships, starting working 3 jobs and very aggressively paid down my loans the minute i got out of college).

anyway... i dont know if i should use the snowballing method, which is fine, but mentally i can't wrap my brain around having this debt hanging over me for the next few years. if i use my emergency fund i don't know if it's playing russian roulette not having any cash on hand in case something bad happens at a job or i have a medical/family problem.

is there any default recommendation with regard to this kind of thing? i've looked and asked around and can't seem to find a "go-to" recommendation.

thanks in advance for all of your help and advice. this is a great forum and it really fosters the whole idea that we're all in this together, which i firmly believe. it's a tough time but hopefully we'll all make it through :-)

[KevinW]

Dave Ramsey says to establish a $1,000 emergency fund, then pay off all debts, then fill your emergency fund out to 3-6 months' expenses. So he would say to use all but $1,000 of your savings to pay off the credit cards.

In strictly mathematical terms, interest rates on credit card debts are much higher than on cash savings accounts, so the optimal thing to do is hold just enough cash to cover the emergencies you experience, and direct all other money to paying down the debt. Of course it's fundamentally impossible to know how much your emergencies will cost before they happen, which is why there isn't any one "go-to" answer. You have to strike a balance between preventing additional debt (emergency fund) and reducing existing debt. Personality is also a factor, as debts and low savings make people anxious to varying degrees.

In an emergency you need cash to pay for rent and debt service, but could charge just about everything else if it came to it. You say you have a stable income that covers your rent and minimum debt payments, so if I were in your position I think I would follow Ramsey's advice: keep $1,000 savings and use the remaining $3,500 to pay down your debts.

[zanyzach37]

thanks for the advice, kevin!

my main concern is that if something happens and i don't have cash available, i'll have to turn to credit cards, which will only send me back into the problem i'm trying to fix. the advice you gave is great and it makes a lot of sense. i guess i just keep hearing the "you're an idiot if you're not actively trying to get 3 to 6 months of emergency funds put aside" so i'm a little nervous to take a big chunk of that money and put it against the credit cards, eventhough it definitely makes financial sense (as far as the interest i'm paying).

[khorrell]

I understand your situation, and I struggle with it regularly. It is hard to keep that money in savings when it is so tempting to pay off the credit card.

I'm trying to keep a decent amount in reserves ($2500 for us) while still making decent attacks on our debt.

It sounds like you are pretty smart about it. Good luck to you!

[B Simple]

I would recommend reducing your credit card debt a little bit at time. Instead of wiping out your entire emergency fund. Yes its very tempting to just pay it off but that leaves you no emergency fund if something happens.

Rough calculation if you wanted to pay off your debt in 12 months you would need to apply roughly $558.00 per month to your credit card balance to eliminate this debt. Not knowing how much you earn per month from your freelance work, I would apply at least $500- $600 per month in addition to your current monthly payment if you can. This would eliminate the need to use all of your emergency funds.

So begin applying all of your additional income to your credit card debt to eliminate this debt as quick as possible. By doing this you will still have emergency funds if needed. Hope this helps.

[RCThinkWealth]

Having listened to Dave Ramsey's radio show a good bit lately, he usually only recommends stopping the debt snowball for a while when the ability to earn income could be lost-such as pending job cuts, etc. This is not really your situation as you have a regular job plus freelance income, so it comes down to what makes you feel comfortable- if you can live off the income of your 1 regular job, and you feel comfortable doing it, it is probably OK to follow the snowball method and use all but $1k to pay it off.

[lucille]

With the economy the way it is, having 4 months of living expenses held in reserve is certainly not a bad idea. Jobs are never as stable as people think they are, with the unknowns of the economy right now I would be very reluctant to spend that money unless moving back in with mom and dad (or something similar) is still an option for a fall back plan.

[MNfrugal]

We paid off a car loan in half the time given (3 years instead of 6 years) by using a method similar to what B Simple recommends. I really enjoyed watching the remaining loan amount decrease rapidly with this method! And we saved a ton of money by not paying all the interest.

I'd encourage you to make a budget based on your STABLE INCOME and BASIC EXPENSES. Save a percentage of your freelance income (15%?) to pay your tax bill. Use the rest of your freelance income to pay down the principle on your credit card debt.

[Philip Brewer]

The key is to find the right size of emergency fund for your circumstances.

For example, it's silly to build up enough cash in your savings fund to eliminate your debt, and then wipe it out in one fell swoop--if you think a zero balance in your emergency fund is okay, then you'd pay a lot less interest if you just zeroed it out now and got those credit card balances part-way down right now.

But, of course, a zero balance emergency fund is risky, so that's unwise--now or when you've got enough to pay off the cards.

If you don't have debts, you want 3 to 6 months expenses in your emergency fund. That's because it can easily take 3 months before you know whether it's going to be possible to quickly find another job if you lose one--and then you need another 3 months to carry you while you make the necessary adjustments to your household cost structure if you can't.

If you do have debts, then you're in a different position. In particular, there's no conceivable change in your household cost structure that could let you get by for long without a job anyway. In that circumstance, all your emergency fund really needs to do--all it really can do--is smooth out cash-flow glitches.

By cash-flow glitches I'm mostly thinking of expenses that are affordable over the course of a year, but that you don't otherwise have cash for--a car repair expense that means $1200 today rather than the $100 a month that you've budgeted for. It's also important, though to allow for problems getting paid (computer problem at work causes your payroll deposit to show up one business day late).

So, my advice would be to figure out how much you need for that sort of minimalist emergency fund--one month's expense might be a good ballpark figure. Keep that and put the rest on your credit cards right now. You'll get your debt paid off at about the same time, save money in interest, and not have to run your emergency fund down to zero--not even briefly.

I've written before about Figuring the size of your emergency fund.

[zanyzach37]

Wow, thanks everyone for the plethora of great advice!

Perhaps what I will do is leave $2000 or $2500 in my emergency fund and apply the rest to credit cards. I'm hoping to get a large refund and will apply that directly to my credit cards as well. Hopefully after all is said and done I can start 2010 free of credit card debt.

A somewhat related question.... If I have a supplemental retirement plan (on top of my 5% contribution, which my employer adds 7% to, i contribute an extra 10%) should I be applying that to my debt every month, or is it a good time to invest it in a long-term retirement fund? I'm maxing out my IRA to $5000 each year and since I'm only part time at the company that gives me the 403(b) I'm trying to save an aggressive amount from that salary because 12% of not so much equals... well... not so much. Ultimately the additional 10% that I'd be contributing amounts to something like $190 a month.

I've heard that now is the time to be upping your retirement contributions because the market is so low that you have more buying power. But I also know that I'm not doing myself any favors by staying in debt and it might be foolish to be applying money in any direction other than paying down that debt.

Thank you all, again! This is a really wonderful place and it's so great that people are so supportive of eachother and willing to dispense information. Coming from someone new to all of this who is making an effort to start his financial life off on the right foot, I sincerely appreciate it. :-)