Emergency Funds and Debt Management
Many people who have experienced unforeseen expenses will likely tell you how happy they are to have had an emergency fund. Those without will talk of the difficulties in scraping together the necessary funds. Before worrying about investments and building out your financial plan, make sure you have not forgotten this key piece of “preplanning.”
What is an emergency fund, and why do you need one?
An emergency fund is money you set aside to cover unexpected expenses that arise throughout the course of your life. Losing your job, paying medical bills, and repair costs related to your car or house are all examples of when an emergency fund will be key to weathering the storm. This account can be viewed similarly to a life insurance policy. Rather than paying premiums to a company, you will be paying money to yourself that you can access at a later date in time. This cash can be accessed quickly whenever you need it most.
How much should I have saved for an emergency fund?
A good rule of thumb is to put three to six months’ worth of living expenses into your emergency fund. However, depending on your preferences and income level, the necessary amount can vary. You can start by adding up your monthly living expenses related to mortgage or rent, utility bills, groceries, and vehicle expenses. At a minimum, you should save enough to cover these expenses for three months. For added protection, save up to six months. If you are in a dual-income household, it is unlikely you will both be unemployed at the same time, and the minimum may be sufficient. For others with more risky employment, higher amounts may be appropriate.
The bottom line:
Rainy days happen. If you are not prepared, you may be forced to take out an expensive loan or withdraw from your retirement accounts, likely paying a penalty and taxes. With an emergency fund in place, you will have peace of mind knowing you have taken the necessary steps to protect your plan.
Debt can feel overwhelming, and without a plan in place, it can quickly spiral out of control. Below we will discuss two methods you can implement within your financial plan to manage debt.
What type of debt can these methods help with?
Debt snowball and debt avalanche apply to most consumer debt: personal, student, and auto loans, credit card balances, and medical bills. These methods will not work and should not be tried with mortgage repayments. These two methods share similarities in that they require you to list all your debts related to those listed above, pay off the chosen balance of one account, and continue to do so until you have cleared all debt. The specific differences will be shown below.
What is the debt avalanche?
The goal here is to pay off your highest interest debt first. It involves making minimum payments on all of your outstanding debt, then using the remaining cash flow you’ve allocated for debt to pay off the account with the highest interest rate. This method may be the right fit for someone with strong discipline and the desire to pay off their debt the fastest while incurring the least interest costs.
What is the debt snowball?
The goal here is to maximize the psychological benefits of debt payment. Instead of prioritizing debts with the highest interest rate, you pay the minimum amount on each of your debts and then apply all available funds towards the smallest debt balance. Once one debt is eliminated, the process continues to the next smallest balance. This will not minimize interest payments but will more quickly eliminate your number of debtors, which can keep your motivation and emotions high.
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