The True Cost of an Emergency Fund: A Case Study

Different blogs including Punch Debt In the Face and Earnverse have recently covered the topic of emergency funds.  More specifically, they address emergency funds vs. paying down loans.  It seems to be a popular topic, and I know I’m always looking for the “right” answer to this.

Now I have known for as long as my eyes have been financially open (which is about 2.5 years) that one should have 8-12 months of emergency fund.

You know, some day.  When I am out of debt.*  But what about until then?!  How much is enough, or would any extra money better serve me by paying down my debts and putting me in a better position to handle future uncertainty?

I was interested to see that author and reader discussion in both referenced blog articles settled on an interim emergency sum of $1000.  My reaction was: that’s it?  I realize costs vary regionally, and I do live in Taxachusetts where everything seems to cost more.  But $1000 to me sounds like an insult to the financial mishap gods, a gloves-off girly slap in the face of pragmatism.  You could have a single laptop or cell phone emergency that would land you pretty well in the hole with that kind of bank.  I do not want to be a single gadget away from ruin, even while paying off loans.

I would think the main point of an emergency fund, even an interim one, is to cover whatever you think might happen [during that period of time] without causing you to go into credit debt (a.k.a the worst thing that could probably ever happen).  I know because this happened to me!  And even with the flush $1000 emergency fund I had at the time.

Back then, I thought I would only ever have silly little girl problems, and had not had any yet.  But in fact a slimy, hulking problem was brewing inside my own mouth.  A $4000 dental problem doubled to $8000 because I did not act quickly enough in distaste for taking on too much credit debt.  Naturally this led to more credit debt and a short term second job.  Unfortunately, medical issues can become financial nightmares if you use lack of cash as an excuse to react insufficiently or too slowly.

So when I think about whether emergency fund money would serve you better paying down moderate interest rate student loans now, or potentially preventing high interest rate credit debt at some point, I see it both ways.  Having never been very mathematical before, I decided to get properly mathy and see what I could do with this question.  I give you: the case study.

Right now I have about $5400 lying around and some student loans, the highest interest-bearing of which I am making targeted, accelerated payments on.  My question is: how much is the $4400 more than the socially accepted $1000 worth to me sitting in the EmFund, or inflicted brutally upon a loan of choice, in the event that there is, say, a $5400 emergency?

Sitting in EmFund

The status quo.  It must have been so easy for people 10 years ago to ponder whether to use extra money to pay low interest student loans or to accumulate riches in a higher interest rate savings account (in addition to creating a safety net).  The answer is the savings account.  Duh.  How nice for them.

Now, with savings accounts currently bringing in the amazing return of absolute squat, whether to bother with one becomes a real psychological or even emotional question.  Especially due to the vulnerability and exposure of aggressively paying down loans.  Your money is not making any money for you, and its presence stacked in a bank account prevents you from putting out interest-accruing fires elsewhere.  So in the EmFund, $4400 is worth exactly $4400 to me, and together with the other $1000 would allow me to enjoy all the security it offers.  But that is all.

Brutally Inflicted on Loan

This is where the mathy part comes in.  I used this nifty Excel tutorial to create an amortization table (and highly recommend this for anyone who really wants to get personal with their loans).  I also put together a little credit card periodic interest formula to help me understand the dark side of brazen loan paydown zeal.

Interest saved throwing the cash at a loan:

With my amortization table I discovered that even with my accelerated $1800 monthly payments to my $14k, 4.13% interest loan, I will pay $5646.97 in interest over the life of the loan (gross).  If I were to make a magic $4400 extra payment on top of all of this tomorrow, my total interest paid would reduce to $5541.91, for a total interest reduction of $105.06.  Not bad!

Money lost should a $5400 emergency then happen:

In this case, I would be able to pay $1000 immediately in cash (from EmFund), and would have to put $4400 immediately on a credit card.  I would be able to pay $1800 that month to the credit bill (instead of toward the loan), and there would still be a $2600 credit balance.  Two more months of finance fees and time missed paying loans would result (with an additional $1800 payment and another for roughly $850).  The first month finance fee on the resulting $2600 bill would be $29.97.  And the next month’s would be $14.41, for a total of $43.58 in credit card finance fees before all is done.

But wait, there’s more… due to those 2.5 months of no extra loan paydown, my total amount saved on loans would plummet from the baseline $105.06 to $28.52.  Still $28.52 better off than I was leaving the money in EmFund, but that is quite a hit.  And when you factor in the crazy amount of finance fees over 2 short months, you have $15.06 in dumb interest/fee related costs ($43.58 – $28.52) for the luxury of time-phased payback.  Keeping the money in EmFund makes more sense in this case due to the $15 loss, marginal though it is.  And that is if you think an emergency is likely to happen, or if you are non-superstitious enough to want to scale by probability of emergency – which I am not interested in doing.  I am a non-mathy superstitious weenie and this is as far as I go.

So the math helps a little, but the “right” answer depends on what makes sense for your life.  Obviously it boils down to a financial rock-paper-scissors: savings yield no “good” interest, loans definitely accrue moderate “bad” interest, and credit potentially accrues huge “bad” interest.  Credit “wins” and you just want to avoid credit.  Which is easy to do if you save.  But there’s also money to be made in attacking loans.  If you get too brazen about savings in favor of loans, you may land right in credit’s lap.  But “dumping all the money into a loan now” and “saving all the money forever” are not the only choices, and I will explore another option in the next entry.

* Which will be soon.  Very soon.  Due to accelerated loan paydown.  If you are planning to be in debt for a long while, go ahead and build up your full emergency fund now and prepare to spend the rest of your days and dollars putting out loan fires all over the grasslands of your life.

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