Is Suze Right? Do Emergency Funds Now Trump Debt Repayment?

Recently, an astute reader pointed me towards a very interesting Yahoo! Finance article entitled Suze Orman and the New Rules of Credit Card Debt. In the article, Suze changes her usual tune of paying down debt above all else – here’s a key quote:

“If you have an unpaid credit card balance [and] 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.”

Furthermore (with my own emphasis added):

Orman says that all spare dough–after making the minimum payments–should go into an emergency savings fund. Ideally, she says, that fund should contain eight months worth of living expenses.

This is a pretty surprising shift, since Orman was, until very recently, a very strong advocate of focusing on eliminating all high-interest debt. Obviously, this shift has been brought on by the recent economic downturn – but is it really a sensible change in philosophy? I’m not so sure.

Let’s start with the basics. My philosophy on debt repayment is pretty typical: get a small emergency fund built up, then start snowballing all of the high interest debt (anything over about 6% or so) by focusing all of your energies on paying off the debts in order of descending interest (highest interest first). If you’re interested in how to get this philosophy rolling in your own life, I’ve discussed it in detail before.

Suze used to have a very similar philosophy, but now it’s changed in one significant way: instead of a small emergency fund at the start, she encourages people to get an eight month emergency fund before continuing on to repaying debts.

Although I agree with Suze that a change in strategy is appropriate, I disagree with this particular change.

First of all, it’s a long term solution to a short term problem. Many economists expect the economy to rebound in 2010. A typical estimate is that the recession will drag on for a total of eighteen to twenty-four months, with a bit more than half that time already elapsed.

What about jobs? The rate of job loss is slowing down across the country and in some areas is already beginning to rebound.

In short, it’s quite reasonable, based on the information before us, to conclude that we’ve already caught the brunt of the storm and that the future holds an economic rebound.

In this environment, making the decision to jump from debt repayment to emergency fund building is about two years overdue. Of course, two years ago, many fewer people would have listened to such advice.

At the same time, proposing an eight month emergency fund is really poor money advice to most people, particularly in the face of such a short-term concern. Eight month emergency funds are long term goals, taking years of careful planning and consistent saving to build. Proposing such an enormous goal to someone facing a big pile of monthly bills and a typical income isn’t great advice.

I know this from experience. If you had told me a few years ago that I should have eight months’ worth of living expenses in the bank, I would have laughed at you. It simply wasn’t realistic.

I propose a different solution.

First of all, ignore a huge, long-term goal like an eight month emergency fund. It took me years of difficult decisions and hard saving to reach that kind of buffer – and I had a strong income and a stubborn streak behind it. Sure, it’s a great long term goal, but if your focus is on getting through the downturn, your focus should be on the short term.

Instead, if you’re worried about the downturn, focus on three key things through the rest of this year (and thus, likely, through the bottom of the downturn):

One, apply some realistic frugality in your life. I’m not suggesting completely revamping your life and completely altering your behavior – that will simply fail most of the time, just like a crash diet.

Instead, look for truly effective ways to trim your spending, particularly things you can do one time and have them continually save money over the long haul. Work on improving energy efficiency, for example, by air sealing your home, installing a programmable thermostat (and actually programming it), and using more energy-efficient equipment (like light bulbs and appliances). Prepare home-cooked meals in advance and freeze them (so when you’re busy during the workweek, inexpensive homemade meals are very easy). Call and get your credit card interest rates reduced. Cut out services you’re not using – and try to negotiate any package deals you have, like a cable/phone/internet bundle. All of these tactics can be done once in a big energetic flurry, but they trim your monthly expenses thereafter.

Two, acquire no new debt. Instead of replacing things, stretch out their use a little bit longer or find alternate means. Take your credit cards and hide them, so you’re not tempted to use them for things you don’t truly need. Most importantly, take it one day at a time. Focus on just avoiding the credit cards in the here and now – don’t stress out about the long term.

Three, build up your emergency fund a little now, but be prepared to reduce it in 2010. If you’re really concerned about the short term, it’s okay to slow down the debt repayments in the short term. Just pay the minimums and put the extra payments (along with all of that other money you’re saving through the steps above) into your emergency fund. Then, when the economy rebounds and you’re clearly in a more secure state with your employment and other factors, don’t be afraid to put some of that savings towards your debts.

To put it simply, an eight month emergency fund, if you have high interest outstanding debt, is overkill. However, in the current economic environment, there is reason for people to feel much less secure about their employment. So, in the short term, I’d bulk up my emergency fund a little – but only in the short term.

If you take nothing else away from this article, take this away: everyone’s personal sense of risk is different. For many people, the current economic state goes far beyond their comfortable risk threshold – if you feel that way, bulk up your emergency fund in the short term. If you feel confident and comfortable where you’re at, pay down your debt – or, if you don’t have any debt, start saving for retirement. The key, as always, is to spend less than you earn. If you do that – and do it with all your might – the details of whether to pay down debt or to have a bigger emergency fund pale in comparison.

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