Paying Off Debt Versus Building Emergency Fund

Question: Are you an advocate of building an emergency fund while you pay off debts or do you recommend paying off debts first before you start building an emergency fund?

The debt referred in the question does not include mortgages but does include student loan, credit card loan, auto loan, and home equity loans.  I’m sure there are other types of debts out there but these four are the major ones I could think of.

After I paid off my auto loans several years ago, I opened an ING Direct account to start an emergency fund, which I contributed every month.  I had accumulated little more than $13,000. My intention for this emergency fund was to cover all the bills in an emergency situation such as if I were to unexpectedly lose my job or if I needed money to cover any high expense health related expenses.  My intention was not to use for any unexpected expenses such as fixing a car or home repair or any unexpected high bills because my goal was leave my emergency fund alone as long as possible without draining it.

The only debt I have, besides my mortgage, is the home equity line of credit (HELOC) loan as I already paid off my auto loans and I always pay off all my credit card payments every month.  My goal was to pay off remaining HELOC loan as soon as possible so I had been thinking about using my emergency fund to partially pay it off.  After going back and forth about whether to use the emergency fund, I finally decided to do it and made a big payment last month.  The reason is simple.  It’s the immediate money saving that made me make this transaction.  My emergency fund was getting about 0.5% in my ING Direct account while I was paying 2.75% on the HELOC loan.  Unfortunately this left me with no emergency fund.  In fact I will not be able to start building another emergency fund until all the HELOC loan is paid off, which leaves me at a vulnerable situation.  Did I make the right decision here?

To mitigate this risk of not having an emergency fund available when I need it, I started to think of my options and was able to come up with 5 decent options.

Receive Financial Support from Parents

I like to be self sufficient and don’t want to rely on my parents especially when it deals with money.  However, if I was to be in a situation where I needed their help, I am willing to ask my parents for their financial support and I’m sure they are willing to help, right?  To make this a feasible option for me and my family, I can start talking to my parents now about my plan to use them as financial risk mitigation plan and receive their agreement.

Borrow From Home Equity Line of Credit (HELOC)

Since I already have a HELOC opened, I can always rely on it to borrow money when needed.  It gives me financial flexibility by having this HELOC available.  It might be a good idea for those who already own a house to open a HELOC in case of an emergency.  But be aware that the interest rate could go up in next several years.  Therefore, you do not want to accumulate too much debt with HELOC.  Also, by opening a HELOC, you are essentially using your house as collateral.  Therefore, it can be risky and I do not recommend this to just anyone.  Nonetheless, I can always depend on my HELOC in emergency situations and no credit check is required once you have approved HELOC.

Whole Life Provides Cash Value

I am fortunate that I have started a whole life insurance when I was in my twenties.    After 9 years, I have accumulated cash value of more than $9000 and it now gives me an extra financial flexibility by giving me the option to borrow from this $9000 if I ever need some extra cash or just taking the cash after cancelling the whole life insurance (which by the way, I will not be doing). Borrowing from your whole life insurance does not require credit check.

401K To the Rescue

Having the flexibility to borrow against your 401K plan is good news especially to those who need quick access to cash without going through a credit check.  However, be very careful when you consider borrowing from your 401K and definitely understand all the disadvantages associated with it.  I would use 401K as my absolute last option.

Benefit of 0% APR Credit Card

I understand why people do not recommend borrowing from your credit card but I do not want to underestimate this option when I need some extra cash in emergency situation.  For me, borrowing from a credit card that provides 0% APR is a great option since I already do not have other credit card debt.  However, I would have to find and apply to a credit card that provides this promotion.

As you can see, I have several options for me to reach out financially in emergency situations despite not having an emergency fund available in my back pocket.  Obviously, my primary option would be to tap into my HELOC again if I were to be in an emergency situation where I needed extra cash.  Because of this option, I decided to use my emergency fund to pay off my HELOC debt to save almost $300 per year or 2.25% in interest.  Would you have done the same thing or did I make a mistake getting rid of my emergency fund?

  • SB @ One Cent At A Time January 6, 2012 at 7:45 pm

    An emergency fund is one you can take out within hour. Can you borrow money from 401k that fast? Not all 0% APR are valid for cash advances, be careful before depending on that option.

    I would rather build a little emergency fund before starting paying off debt. After all this is personal finance and every one has thier own choices.

  • Paul @ The Frugal Toad January 7, 2012 at 5:34 pm

    I would have to agree with SB with the emergency fund. I would have a hard time sleeping at night knowing that I did not have enough funds to fix a broken appliance in an emergency.

  • Ginger @ Girls Just Wanna Have Funds January 8, 2012 at 5:39 pm

    I don’t know that I see any of these options as concrete alternatives unless you were in dire need of the money ASAP. By dire I mean someone is either bleeding or in jail.

    That said, as others have mentioned, personal finance is just that personal. And none of us truly know what decisions we will make until we’re in the same shoes.

    I think you made the right and very brave decision to pay off the HELOC, however I would look into other options than the ones presented above as they would net you more debt once the emergency is over.

    • UltimateSmartMoney January 9, 2012 at 6:39 pm

      What other options were do you consider? Thanks.

  • Monica January 8, 2012 at 6:11 pm

    You’ve already paid on your HELOC and depleted your emergency fund, so now you have to find a way to start building it up again. I would review your expenses, and cut as much as you can in order to put any savings into a new emergency fund. Even if it is only $50-$100 a month, at least it’s something, and any extra money, tax refund, bonuses, etc. should be put into your fund as well. It is just my opinion of course, and I good luck!

    • UltimateSmartMoney January 9, 2012 at 6:40 pm

      You’re right. I am currently trying to build my emergency fund again. But until I have a solid emergency fund, these are my options in case I need the money early.

  • YFS January 10, 2012 at 3:34 pm

    I personally would not have made the decision you made with exhausting your emergency fund to pay the HELOC. The reason is simple. You exchange 13k for a 1 year savings of 300 dollars and your alternatives to get out of an emergency come at a higher cost then the interest you would be paying on your HELOC. I would have left my emergency fund alone and paid down my HELOC as planned.

  • John | Married (with Debt) January 10, 2012 at 4:03 pm

    I think you made the right choice. I have been foregoing building a strong emergency fund in favor of debt payoff (7 more months!). The security that comes with debt freedom is greater, in my opinion, than having the cash sitting there. Like you, I have cash sources that I can tap if a real emergency hits.

  • Vineet July 6, 2012 at 4:10 am

    All your options talk about borrowing more and more money in case you are in trouble. Why dont people understand that emergency fund is cash. Borrowing is always on someone’s discretion and I wouldn’t ever want to have someones will associated with it when I am in emergency.

  • Lindsey October 22, 2012 at 1:59 am

    Because life is full of the unexpected, i would rather save a small emergency fund first and then start paying off my debts as fast as i can. In this way, i can have the peace of mind that should something happen along the way, i have some little money somewhere that can bail me off. I like this topic alot. Thanks for asking.

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