Don’t Pay Down Debt?

by bigcajunman on July 6, 2011

An interesting Quandary

My statement about debt has been that if you find money, you should throw it at your debt (if you have debt) until you no longer have any debt left, then think about creating emergency funds and such. You will get better pay back on your funds by paying down your debts, than you will on most things you might invest in (IMHO). It seems obvious, but I have had many folks argue with me that found funds should maybe go into an emergencies or rainy day account.

I have in the past dismissed this argument, but a very good point was made to me by one commenter (yes I do read your comments).

The point made was that if you don’t have an emergency fund you will have to use your debt vehicles as your emergency fund, which in some situations might be OK (i.e. the furnace blows up, the roof leaks, etc.,) for a sudden catastrophic one time expense, but if you suddenly lose your income and have no money put aside, you will then be drawing down on a regular basis your debt vehicles, which banks do not smile upon (especially if you are not making payments on the same debt vehicle).

An example would be if your company suddenly failed (e.g.Nortel) and you don’t get any severance and you have paid a great deal off your house, but you have very little in your emergency fund, you now may be able to negotiate a lower payment on your mortgage for a while, but will Unemployment payments be enough, or will you suddenly start living off your credit cards and/or lines of credit?

This is an interesting predicament and my compromise statement to my normal pay down debt stupid (PDDS) would be to have a 3 month net income cushion in some savings vehicle, that can be used in emergency and then once that is in place all future moneys should be thrown at your debt until it is dead.

Here is the question for the day, do you think it is better to go all out and pay down debt with extra moneys, or is it better to build up savings and pay down debt in a more conservative fashion?

{ 15 comments }

{ 14 comments… add one }

Bankruptcy Ben July 7, 2011 at 9:14 pm edit
An offet account is a feature on mortgages where you have a savings account with the same bank. The amount of money in the savings account offsets the principal of the mortgage and saves you interest. Eg you have 10,000 in savings and a mortgage of 150,000. If you had an offset account interest would be calculated on 140,000. 90% of Australians have floating rate mortgages with daily compounding mortgages so interest is calculated on a daily basis.

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- bigcajunman July 8, 2011 at 4:52 am edit
  Interesting, no haven’t heard of that in Canada yet.
  
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Juan July 6, 2011 at 10:23 pm edit
Personally I must vote for the duel action situation. I think that the biggest part of risk management on a personal finance basis is to manage one’s cash flow. If one does not have an emergency fund built up then cash flow management could be very difficult if one’s salary was to be temporarily stopped. In terms of reduction of risk I think that one absolutely must work on a rainy day fund at the same time as paying down debt.

One can not sacrifice the short term reality [the possibility that one's normal income source might be turned off] for the long term goal [no debt + good income producing assets].

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Rachel Levington July 6, 2011 at 8:54 pm edit
Canadians’ rate of saving is declining and it’s important for Canadians to be aware of the risks and possible consequences of taking on a large amount of debt. How much debt do you have right now and how are you managing it? Do you know your debt to income ratio? If it is more than 50% you need to start managing your debt. Trustees can assess your current financial condition and help you establish a personal budget to begin managing your debt and preparing for the future.

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My Own Advisor July 6, 2011 at 8:02 pm edit
Good post BCM. However, everyone is different. While no debt is likely the best debt, I believe some debt is just fine for folks. It just needs to be managed well. I don’t see how this is different than investments, relationships or any other “assets” in somebody’s life. Debt is not ideal, I don’t like it, I want to get rid of it badly, but it doesn’t consume me. Overcompensation in one area, debt reduction, might do some folks much more harm than good. Life is about balance and everyone is entitled to find their own.

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Bankruptcy Ben July 6, 2011 at 7:12 pm edit
If you have mainly credit card debt or a mortgage with an offset account (i assume this is a common feature in canada) an emergency fund is a stupid idea. If your debt is personal loans/car loans and or credit cards that have been closed or are over their limits an emergency fund is a good idea. The idea than an emergency fund is a cure all is ridiculous and bad unqualified advice.

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- bigcajunman July 6, 2011 at 7:50 pm edit
  Not sure what is meant by an Offset account, is that where you can build up extra equity?
  
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Shaun Somers July 6, 2011 at 12:14 pm edit
I think a $1000 emergency fund is best when still in consumer debt. It’s big enough to cover most things that could come up. No, it won’t be great if all income is lost, but that’s a risk worth taking to avoid having 3 full months in savings while still in high-interest debt.

Some people feel comfortable enough with $500 (maybe they don’t have a car), others want $2000, but I wouldn’t go higher than that.

Once all non-mortgage debt is gone, only THEN would I say to work at saving up 3 months worth of expenses in an emergency fund.

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- bigcajunman July 6, 2011 at 7:50 pm edit
  An interesting point of view, I kind of agree with your sentiments as well.
  
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The Borrower July 6, 2011 at 12:06 pm edit
I believe it depends on the credit vehicles you use, the income streams you have, and your own personal tolerance level.

For instance, my debt is entirely mortgage related. I utilize an equity line that is in the 4% range (currently with a balance from a mortgage paydown, not consumer debt), and this is also my safety net. I would rather take all available cash to eliminate the 4%, than to try and save in a 1% ING account. I did this experiment earlier in the year and failed drastically, opting to just move it all to the equity line. However, for a brief moment in time I felt secure with the cash.

Also, we have multiple income streams. This has been a life saver when one drops off, the others can carry the load. Having more than one income stream allows you to slam debt, without as much concern for lean times.

Ultimately, it is a personal choice based on what one can handle (like nancy said above).

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DanP July 6, 2011 at 10:14 am edit
I’ve always thought that it makes more sense to pay down any and all debts using extra cash, and keep an empty Line of credit for emergencies. To have outstanding debt at rates of over 10%+ while having an “emergency fund” getting 2%…just doenst make sense to me.

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bigcajunman July 6, 2011 at 7:30 am edit
Charlie, you are “that guy” aren’t you? Moneys really isn’t a word at all, but I like using it (not sure why, I don’t like saying anys…).

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Charlie July 6, 2011 at 6:59 am edit
How about you change the y to i and make your plural ies as in monies or better yet just leave it as money since it is a non-count noun.

Now you should fund your emergency fund as your first priority. Paying off your credit card while living in your car because your lost your house due to lack of savings defies all logic for me.

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nancy (aka moneycoach) July 6, 2011 at 6:07 am edit
OK I’ll bite. And be contrarian. I think individuals need to know themselves, and do whatever works for them, even if it may not make total $$ sense. By that I mean: if people are fatigued and never seem to get rid of their debt (easy for it to take years when large LOCs are involved, or mortgages) it will probably feel more inspiring to build up a fund instead. Feeling more inspired generally leads to increasing smart-choices with money, so in the long haul would yield a better net worth.
Alternatively, if putting money towards debt gives a sense of relief whereas building up funds are likely to be plundered, then by all means stick with paying off the debt.

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