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Focus on Emergency Fund, Then Credit Card Debt

 
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February 17, 2012
Ask Eva
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QHi Eva,

My husband and I are aggressively paying down our credit card debt. We're down to the last $5,000 on our last card (we've already paid off our two other cards) and have been paying $500 per month. The APR on this card is 18 percent. Well, my husband lost his job last week. He's saying that we should put any extra money we have each month in our emergency fund instead (we have about $2,000 in our emergency fund now). I see his point, but I was so excited about getting out of credit card debt by the end of 2012. So, assuming we still have some extra money each month after bills, food, rent, etc, what should we do with it? Should we divide it between paying down our debt and our emergency fund? Put it all in the emergency fund? Or concentrate fully on our debt?  – Carrie

ADear Carrie,

No surprise you're confused, because even financial gurus like Suze Orman and Dave Ramsey disagree on this particular topic. Suze Orman used to be a strong advocate of pulling out all the stops to pay off credit card debt as fast as possible. However, after the onset of the financial crisis in 2008, she reversed course and instead began urging people to prioritize emergency savings over paying off credit card debt.

Why? You might think it makes little sense to carry credit card debt at 18 percent or higher, while having money sitting in a savings account earning barely 1 percent. Plus, should unexpected expenses come up, if you have paid down your credit card debt, you could always turn to your credit cards, yes?

Well, maybe not. Relying on credit cards to cover essential expenses is always risky, and it's even riskier in the current financial environment. In the wake of the 2008 financial meltdown, credit card issuers aggressively pulled back on lending, slashing credit lines and closing unused credit card accounts for thousands of cardholders, even those who paid their bills on time.Ask Eva

While the lending environment has improved considerably since then, the basic principle still stands: Credit card borrowing is inherently risky, and your credit card limits can be reduced at any time, or the account closed. So, without a large enough emergency fund, you could find yourself in a situation where you don't have enough money to pay the bills.

That, in turn, could trap you in a downward financial spiral. Once you default on bills, your credit score plummets. As your credit score plummets, credit lines could get slashed and new credit will get harder to come by. The price of services, such as auto insurance, may go up. In addition, having bad credit may affect your husband's chances of finding a new job, as some employers consider a person's credit history when evaluating job applications.

This is why Orman changed her advice. Paying off credit card debt doesn't give you any assurance that you'll have money available, should unexpected expenses come up. An emergency fund does. And the costs of not being able to pay the bills are just too high.

The question then becomes how much you should put in the emergency fund. Recommendations vary. Orman recommends saving a total of eight months' expenses. That's a lot. Financial adviser Dave Ramsey advices putting $1,000 into emergency savings and then returning to paying off credit card debt.

In your case, you are in fairly good shape — you have $2,000 in emergency savings, so you don't have to start from scratch. How much you save beyond that depends on your situation. How hard is it to find work in the industry your husband works in? How secure is your job? How much money do you have left over at the end of the month now that your husband has lost his job?

Consider building up at least three months' worth of expenses in your emergency savings account before you resume paying off your credit card debt. Yes, it will cost you some extra money in credit card interest, but that's well worth it, given the consequences of not paying your bills.

That being said, do pay more than the minimum on your credit cards — even if it's just an extra $25 or $50 a month. It helps your credit score and ensures that your card issuer doesn't flag you as a risky cardholder, which could get your singled out for credit limit cuts down the road.


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