Paying Off Debt v. Safety-Net Savings (Given the New Circumstances)

October 13, 2008 9:53 AM

Traditional wisdom suggests that saving money while in debt is a bad idea: you pay hundreds of times more in finance charges on money you owe than you would get in interest on money you save. Under this scenario, your "safety net", at least until you are debt-free, would be the credit lines you are clearing out. However, in a response to a Lifehacker comment I made outlining this traditional wisdom, someone replied that given the financial crisis, companies could then lower your credit limit, regardless of cause, killing your safety net. Given this, is the traditional wisdom now wrong?

Over the months to come, is the wisest place for any money remaining after bills an interest-earning savings account, or still towards reducing my credit card balance? If a mixture of the two, what ratio would you yourself recommend? Finally, what would you yourself consider a minimum balance to reach for your safety net, if you felt the traditional answer of six months' salary was, for now, too high a goal to be practically reached?

posted by WCityMike to work & money (19 comments total)

depends on how soon you can find another job. Unemployment insurance lasts for 6 months, so that's some safety net.

Credit lines are pullable when your credit score falls, but I think 6 months of savings is plenty.

Depending on your age and skills, if you can't bounce back after 6-9 months then something is seriously wrong.

So after the safety net is earning its ~3% in an online savings account, I'd go after the bills, starting with the highest rate first.

So far, the "credit crisis" is somewhat overblown, I think, at least for those with reasonably non-troubled credit histories. If we are in a liquidity trap, then the problem isn't necessarily a lack of credit, but a lack of borrowers who can safely shoulder the debt. fwiw, my mailbox hasn't been lacking for credit offers, I'm strongly tempted to take my REI card's offer of 3% for life of the balance. I paid off my car with a similar offer from Citibank.
posted by troy at 10:05 AM on October 13, 2008

For credit card debt, presumably at 15% or higher, the no-brainer answer is that it's wisest to pay that off as rapidly as you can. If you have a good record paying on time, etc., there's no reason they would reduce your limit; they're still in the business of lending out money at high rates. But, your credit limit should not be your safety net. So once the cards are paid off, start a savings plan to create whatever emergency fund you think you need. How many months' salary depends on how secure you are in your job, and how difficult you think it might be to get another one; there's no one-size-fits-all rule of thumb.
posted by beagle at 10:07 AM on October 13, 2008

It's worth noting that the "traditional answer" is six months' expenses, not six months' salary.
posted by 0xFCAF at 10:09 AM on October 13, 2008

I like the Dave Ramsey debt snowball plan. It suggests saving a minimal emergency fund at the outset, enough to cover crises that could come up in the course of your day-to-day life while you're paying off debt, to avoid relying on credit as a backup. He suggests $1000; some people will need more. Put this in an interest bearing, safe account, and don't touch it unless you have a true emergency (e.g., you will be without food, shelter, transportation, or some other necessity without it).

Then, begin throwing all of your money at your debt, beginning with the debts with the lowest balances (so that you have some small victories at the outset and don't get discouraged. If you're a math-y type and prefer to start with the highest interest rates, do that, but most people are spurred on by the small victories.) Do this with all debts except your mortgage, if you have one.

Once you've paid off all of your debt, then save 3-6 months of expenses (or more if that's what it takes to make you feel secure) in an interest bearing savings account. You are then ready to think about long-term investing, making extra mortgage payments, etc.

I like this plan because it's sensible, simple, and conservative. If you've been in trouble with debt before, you shouldn't rely on debt as a crutch in the future, at least not until you've dug yourself out of your current hole. You didn't get into debt overnight, and you won't get out overnight.
posted by decathecting at 10:12 AM on October 13, 2008

The is significant value in liquidity.
posted by JohnnyGunn at 10:28 AM on October 13, 2008

given the financial crisis, companies could then lower your credit limit, regardless of cause, killing your safety net

It depends on your specific contract, but usually they can and will do this whenever they want. Amex in particular is notorious for allowing you to have a high credit limit when you pay them every month, and dropping the limit to just over your balance if you leave a mid-size balance on the card. I don't think it's very safe to assume that you will be able to use your credit card as a loan when you have financial difficulties, regardless of the current conditions.

In general, I think establishing an emergency fund with at least a few months expenses should be your top priority. Six months is probably overkill, and really as decathecting said you might be able to get away with just having $1000. It's a balancing act between the financial best case (you spend all of your money paying down your debt, everything goes fine) versus the financial worst case (your income goes down or your expenses go up, and you don't have money to cover it). Really the best thing you can do is to just tighten your budget to get your emergency fund built up and debts paid down as quickly as possible, because when you are taking in much more than you are spending you are better off no matter what happens.
posted by burnmp3s at 10:29 AM on October 13, 2008

We just had this question asked. I answered your specific question.
posted by SeizeTheDay at 10:31 AM on October 13, 2008 [1 favorite has favorites]

troy: "Credit lines are pullable when your credit score falls, but I think 6 months of savings is plenty."

Yes, but six months, as noted, isn't a practical goal for me.

beagle: "But, your credit limit should not be your safety net."

Understood. The idea under traditional wisdom is that while you are paying off your cards, your safety net is the available credit you are clearing out; once you're debt-free, saving a "real" safety net is of course your next goal.

0xFCAF — thanks for the clarification on that.

burnmp3s — glad to hear AmEx didn't just do that with me.
posted by WCityMike at 10:35 AM on October 13, 2008

Yes, SeizeTheDay, I saw that question. But I saw nothing that addressed the variation I specifically bring up here, about abrupt credit limit reduction killing a safety net, and the complication that might cause to traditional wisdom. Thank you for your answer in that page, however, as I found it particularly useful.
posted by WCityMike at 10:37 AM on October 13, 2008

(Also, just to address a point in your answer in the other thread, I'm fortunate in that in my particular situation, I can pay rent in credit — my landlord accepts credit cards. Not that that would be ideal under any circumstance.)
posted by WCityMike at 10:41 AM on October 13, 2008

I don't have an answer for you, because I think the safety net also depends on how well insured you are, whether you have dependents, and your prospects for work.

My simple approach, assuming you have reasonable cash flow (enough to pay bills and then some) is to: 1) stay on top of your bills, 2) build up a 3 month's expenses reserve, and 3) pay down your debt.

If you have dependents, then add to the above either death and disability insurance or savings equal to an additional 3-9 months worth of expenses.
posted by zippy at 11:08 AM on October 13, 2008

have an answer -> have a simple answer
posted by zippy at 11:09 AM on October 13, 2008

I was briefly on unemployment in the SF Bay Area, and while it helped, it did not come close to covering rent, let alone utilities, medical, and food. Before you rely on unemployment for a safety net, know depending on your situation, it may not be much help.
posted by zippy at 11:12 AM on October 13, 2008

I always keep cash at hand because card companies could, conceivably, cancel your card for whatever reason, lower your limit, etc.

Example: My cards went into universal default due to a screw up by BOA and all of a sudden I was paying ~26% on purchases on every card I had. If I had to use one of those cards for rent, I would have been thoroughly fucked.

You can always put more money towards the cards if you want, the opposite is not true of getting money back from the credit card companies. You can look at it as money lost to finance charges, or, in my experience, money saved by avoiding emergency cash advances.

I know you can pay your rent with a credit card, a lot of folks have to pay in cash.

Cash advance rates are huge, and if you add them to another balance category they'll be paid last. Meaning, if you have $2,000 in purchases at 10% and $300 in cash advances at 25%, you won't be able to pay the $300 back until after you've paid the $300 back. You can avoid this particular problem by keeping one card ONLY for cash advances with a high enough balance to cover emergency expenses, if you can afford to, but many can't.

So they end up seeing that cash advance sitting on their monthly statement for the next year or two. Ouch.

If there's any way you can transfer your balances to a lower interest rate credit card, that might be a smart choice. A savings account at around 3% tends to balance out the 3% transfer fee, leaving you paying some interest but giving you some flexibility in your payment schedule so that you can save a bit.

Not to mention the fact that in a personal financial crisis you can always stop paying your credit cards. If you have to rely on them for emergency funds you have to keep paying them. All of them, so you don't go into universal default. If you have enough cash in the bank, you can tell them to go screw themselves if you really need to.
posted by sondrialiac at 1:06 PM on October 13, 2008

How aggressive are you about getting out of debt? How high are the credit card rates? Putting away 1-2 months' worth of emergency cash instead of paying off a card at 10% is an okay idea. Putting away 6 months' worth of savings instead of paying off card debt at 18% still sounds like a bad idea to me. Get a 2nd job, sell whatever you can, put yourself on a serious budget. And call the card companies and get the rate lowered.
posted by theora55 at 1:16 PM on October 13, 2008

I am a firm believer in "pay yourself first". It's nice to know there is some money tucked away for that rainy day, even if you are in debt.
posted by scarello at 2:21 PM on October 13, 2008

The one time where it's stupid /not/ to save is when your employer offers matching funds for your 401(k) or 501(c)(3). Matching funds are a 100% return on your investment, and it's almost impossible to beat that.
posted by daveqat at 6:50 PM on October 13, 2008

I just wanted to add that the point of building up some cash reserve is so that, in an unexpected crisis, you don't go bankrupt. But as has been said before, there's no better investment than paying off debt. So, if you have built up a cushion to tide you over in case of job loss or hospitalization - the unexpected non-apocalypse scenarios - paying off your debt should be your top priority (well, aside from not adding to your debt - consolidate those cards, negotiate a lower rate, and then leave all but one at home and only use it in emergencies. Cash for everything else. Making transactions a bit less convenient is the point here).
posted by zippy at 9:20 PM on October 13, 2008

For those who come to this old question later, Suze Orman recommended in April 2009 on Oprah: "If you have an unpaid credit card balance not much saved up in emergency savings, I need you to listen up. My advice has changed. I want you to only pay the minimum due on your credit card balance, and instead, make it your top priority to build as much of an emergency cash fund as you can."
posted by WCityMike at 1:26 PM on August 4