Updated on 09.11.14

Credit Cards, Retirement, Or Emergency Fund?

Trent Hamm

Today, I was reading an MSN Money article by Liz Pulliam Weston where she recommended setting priorities in the order of retirement, then credit cards, then emergency fund. Personally, I rank them small emergency fund, credit card debt, retirement, bigger emergency fund. One of my astute readers pointed out to me that Suze Orman takes yet another tack: credit cards, then emergency fund, then retirement.

With three completely different priority lists, how does someone know which one is the right one to take? This made me think about the reasons behind the difference in order.

First of all, all of these philosophies agree on the most important point: spend less than you make. This is really the first step, and everything else follows from that. If you’re having trouble doing that, cut some fat out of your budget, even if it seems hard. If you can’t consistently spend less than you make, you’re in trouble and something has to change.

Given that, there are two questions that you can answer that will help you figure out your priority list and it should illustrate why Liz and Suze and myself have different ideas on what is the biggest priority.

First, how likely are you to have a significant crisis in the next few months? A car breakdown, a job loss, or a medical issue, for example. The higher the likelihood of such an event, the more important an emergency fund becomes. This means that if you’re married, a fund becomes more important – the same is true for children and for owning a home. What’s the “right” answer here? There is none – it’s actually all about one’s life experiences. It’s impossible to predict the short-term future of someone’s life like that, so in order to advise a priority list, you have to use your own experiences to decide how important an emergency fund is. Looking at the list, it’s clear I think that emergencies are more likely than Suze, while Suze feels they’re more likely than Liz.

Next, how likely are you to run up more credit card debt? I usually believe that when people come around to their financial apocalypse, they become very scared of debt – I know I was – and thus they have no interest at all in running up credit card debt. Liz, on the other hand, assumes that her readers are much more likely to run up additional credit card bills in the next few months. The more likely you are to keep charging, the less vital paying off your credit cards now becomes. Why? Paying them off now means you’ll have lots of available credit, and if you’re prone to charging a lot, it’s like throwing good money after bad. Suze and I are both less likely to think you’ll run up more credit card debt than Liz is.

As a general rule of thumb, the more diligent you are about your finances, the more important it is to eliminate high interest credit card debt immediately. That was the first thing I did after my financial apocalypse and I haven’t run up any revolving debt since, but if I hadn’t stayed off the credit cards, it would have been a waste of my time. Also, an emergency fund’s importance directly relates to how you live your life. If you’re more likely to have a crisis (if you have a home, if you have kids, etc.), then an emergency fund becomes more important.

It’s really interesting to look at how personal finance advice can change depending on who you’re talking to. It truly is personal.

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  1. MB says:

    Wouldn’t all three of you say that contributing to a 401k up to the match is always the 1st priority?

    So mine would go: retirement (up to 401k match), emergency fund (medium-sized), pay down debt, more toward retirement (up to 15% of income), then college (plan to pay for 1/2 — kids finance or get scholarships/work for other 1/2). And then …. I think you should enjoy your money. Loosen up a little. Go to Disney. Eat out. Take vacations — big and little. Spoil your kids (a little). Contribute to your pet causes and charities.

  2. Trent Hamm Trent says:

    MB, from your response, it looks like you think there’s basically no chance for an emergency in the coming year, but there’s some chance you would charge up a credit card. That’s your life and how you see it, not necessarily indicative of the lives of others and how they see life.

    Personally, I’ve seen how badly a major crisis can impact a family and I don’t want everything to collapse because I’ve been pumping into retirement without an emergency fund. Thus, because of my life, I see the priorities differently. That’s the point of the article.

  3. J.D. says:

    My rule-of-thumb is to ignore all rules-of-thumb. Actually, what I always say is to do what works for you. Each of us is different. We each have different psychological makeups. We each have different goals. What works for Trent may not work for J.D.

    The important thing is to move in the right direction. Rather than fussing over which is the perfect choice, pick a choice that you know to be good (and that works for your life), and then do it. So, if paying off credit cards is going to work best with your way of life, that’s the thing you should do first.

    For the record, though, I agree with your approach, Trent.

  4. MB says:

    No … not that I see no chance of an emergency ( I do have an 8 months emergency fund)… just am sure I remember advice from suze and even you in a past post (???) saying you should always first get the 401k match …. or else you are throwing money away. I’ve always thought of 401K contributions as happening before anything else … have contributed at least up to the match without interruption for 15 years now, … not because I think of it necessarily as prioritizing retirement so much as maximizing my employment benefits …. getting the most from my employer.

  5. Trent Hamm Trent says:

    Once you put money away for retirement, you should definitely get the match before doing anything else (Roth IRA, etc.).

  6. Bruce says:

    Pay down your cards. If you have an emergency you might have to run them back up but if you don’t have an emergency you’ll be ahead of the game. And I agree that a 401k match is too good to pass up.

  7. Lazy Man says:

    I say pay off the high-interest credit cards is more important than emergency fund. Mathematically this should always be the best option. The reason is that you can use the credit cards in the emergency cases – even if you have to resort to a cash advance. In essence the credit cards can be your emercency IF you need it. If you don’t need the emergency fund, you are quickly cutting into the debt before it has a chance to continue to snowball on you. If you wait to build a $1000 small emergency fund, you may already be paying an extra few hundred in interest charges.

    In short, in the best case scenario (no emergency), you make well paying off the cards and preventing the interesting from snowballing more. In the worst case scenario (emergency), you essentially break even (pay off the cards, and end up putting more back on).

    If you don’t get a 401K match, I’d ignore retirement completely until the high-interest credit cards are done. If you do get a match, I would prioritize that over the credit cards to get whatever free money I could.

    As J.D. mentioned, people are different and some of these matter so very little, that you really can’t go wrong as long as you are doing one of the items.

  8. Koby says:

    I recently just landed a new job that pays me a considerable amount more than my current one and was wondering where I should put my focus. So this article came at just the right time for me.

    Great job, as usual guys.

  9. Frugal Bachelor cannot help but feel that those who are paying down credit cards at the expense of 401(k) – even without a match – are making a mistake. According to his calculations, a 25 year-old who puts $15,000 into 401(k) this year will have $410,499.61 tax-free .. 40 years from now. That contribution cannot be made up ever again due to annual limit; no matter how you slice it your 401(k) account will be almost half a million dollars less than it would have been if you made the contribution just this year.

    Meanwhile if you used that money to pay off debt (which will only be about $11,000 after taxes) then you’re saving only about $2000 in interest by delaying putting it into retirement by one year – less than the tax break the IRS is granting you.

  10. doug m says:

    as someone who is trying to rid himself of debt and start saving more money, this article has given a little insight as to where i really need to start focusing.

  11. Mariette says:

    Great post as always. I think J.D. has it right when he says everyone is different, they have different fears, and different experiences that inform those fears. Trent has seen the harm that not having an emergency fund can do so it’s natural for him to prioritize that, while someone else might feel completely incapacitated by their credit card debt and won’t feel comfortable putting money away for an emergency fund until they have started to tackle the debt. So long as you are taking responsibility for your financial health and well being, whatever the order, that’s the important part.

  12. Matt Iverson says:

    Ah, the eternal question of debt priorities :) We’ve actually just created a module on this specific issue at the startup I’m working at. Since we’re working with Certified Financial planners, I’ll give you their perspective on an interesting take on the issue of emergency savings:

    Whether it’s better to set aside money in a savings account for you to use in case of an emergency versus just using a credit card to pay for the emergency.

    The interesting situation is when an emergency happens.

    In case of setting up an emergency fund and emergency happens after 1 year:
    1. Keep $10,000 in a hight yield savings account for 1 year (assume 5% return)
    in 1 year the user would have: $500 (Future Value(5%, 1, 0, $10,000))
    the rest of 29 years the user will have $2,058 (FV(5%, 29, 0, $500)
    2. Invest the rest of $30,000 @ 10% return with a $4000/year contribution
    in 30 years the user would have: $1,181,458 (FV(10%, 30, $4000, $30,000))
    Total: $1,184,016

    In case of not setting up an emergency fund and an emergency happens after 1 year:
    1. Invest $40,000 @ 10% return with a $4000/year contribution for 1 year
    in 1 year the user would have: $48,000 (FV(10%, 1, $4000, $40,000))
    2. Emergency comes => borrow $10,000 from credit card @ 20% interest. Instead of contributing $4,000/year towards retirement use them to pay off debt (it takes 3.5 years)
    after 3.5 more years the user would have: $67,003 (FV(10%, 3.5, 0, $48,000))
    3. The user finishes paying off debt => resumes retirement contribution (for the next 25.5 years)
    after 25.5 more years the user would have: $1,175,970 (FV(10%, 25.5, $4000, $67,003))
    Total: $1,175,970

    This is the worst case when the emergency happens right away and it shows that using the credit card is almost as good as having an emergency fund. Now, if the emergency happens after 2 or more years, using the credit card is a big winner getting closer and closer to having as much as $130,000 extra.

    It looks to me that taking a very low risk ($10,000) could have a big payoff ($130,000).

    And the planner’s response:

    “Your analysis is fundamentally correct but there are a couple of practical issues that also should be considered.

    You are assuming no matching funds on the retirement calculations. If those are lost due to paying off the credit card it could swing the numbers in favor of the cash reserve, depending upon the timing and amount of match. (If the emergency is a loss of job then this point is moot)

    There are tax considerations in not getting the retirement deductions while you pay off the CCard. Depending upon the tax bracket this also weighs in favor of the reserve.

    Putting a big balance on your credit card may impair your ability to borrow. If you might need to refinance your mortgage due to a high rate reset the card debt may make it harder for you to get a loan. Lenders generally consider the debt on CCards a bigger negative than the slightly larger retirement account is a positive. Given the pay off period this could be an issue for some, especially in the early years.

    But in general, you’ve hit on an important point here which is that over a long period of time a careful management of risk can really pay off, or in other words don’t be too conservative. If my client was disciplined about keeping zero balances on their cards I’d likely recommend your strategy. If they tend to carry big balances, even if only from time to time, I’d want them to have at least some cash reserve, even if they still had lots of room left to borrow more against the cards. The main thing you always try to avoid is having them ever have to start to take money out of their retirement savings before age 59 ½. Using credit cards as part of that strategy is very reasonable for the right people and as you numbers point out, may even be economically preferable.”

    An interesting twist on emergency funds…

  13. plonkee says:

    Definitely done is better than perfect.

    I’ve got a reasonable emergency fund, but as I have money security issues – i.e. I’m irrational about it – I also have access to about £10K (~$20K) on credit cards. This saves me from having an unnecessarily large emergency fund, so that I can do what I need to with my retirement savings/investments.

  14. Margaret says:

    I just posted this on another blog (linked through the personal finance carnival), but it applies here. I agree with lazy man and bruce in principal (pay off the debt, and if you have to, run it up again in case of emergency). HOWEVER there is a risk in that. I was saving for annual expenses, but instead of putting it into my ING savings account (3 or 4% interest), I put it against my ING line of credit (10% interest). Thought I was a genius, because I was saving the interest until I needed to use the money for payments. I had “saved” about $1400 on my line of credit, when I got a letter stating that my line of credit was being reduced by $1400 due to the number of other debts on my credit report. So there went my savings. While it was good that my overall debt was down, it was very bad that I suddenly faced a very large payment and had no cash flow with which to pay it. I found it quite a coincidence that the amount my line of credit was reduced just happened to exactly match the amount that I had paid off. That rather discouraged my annual savings efforts, but I am trying to get back on track. I will probably try this again, applying the money to a high interest credit card (but have to make sure it isn’t one which will then charge some large cash advance fee which would wipe out any interest savings I might get), but only because I have made some progress on debt repayment, and I am starting to have a little space on my credit cards. If you are nearly maxed out on credit cards, I would be wary of having a limit lowered (although that does also seem like the best time to be getting some cash, any cash, applied against them, doesn’t it?). This reminds me of something I saw on a talk show couselling couples about their finances (think David Bach was the advisor). He was helping the couple decide which credit card debt to tackle first, and he got them to tackle one of the smaller ones. It had quite a high interest rate, though not the highest. The problem was that their limit was around $1000, and they were maxed out. The danger was that the credit card company could decide to reduce their limit by say $200, and then they would be hit by over limit and assorted fees every month that could cost them 2 or 3 or more times the actual interest being charged on the debt. Until it happened to me, I didn’t think your credit limit was ever reduced as long as you always made at least the minimum payment on time (which was the case with my ING account — I had never been late, and I always paid more than the minimum, even if it was just rounding it up to the nearest ten dollars).

    I think my order would be debt reduction, at least of all credit card debt, then retirement with a very small emergency fund contribution (because if it were a REAL catastrophic emergency, I could use my retirement money — I am talking child getting a fatal illness and needing to travel to another country for treatment kind of emergency, not unexpected vehicle repair emergency), then simultaneously contributing towards all three.

  15. Engineer says:

    The very most important thing is none of these three.

    The very most important thing is to SPEND LESS THAN YOU EARN. Otherwise, none of the 3 options in the title will be available to you.

  16. Paul says:

    There really is no cookbook answer because each of us has a unique set of circumstances and place different levels of importance on debt reduction, saving, and investing.

    The most important thing is to establish a game plan and stick to it. Discipline and committment are the keys.

  17. Minimum Wage says:

    What if you earn minimum wage and your disposable income is forced toward debt service? What if an emergency arises?

  18. Margaret says:

    Minimum Wage — you post frequently, and it sounds like you are really struggling. Sometimes, bad financial situations happen, and it does not mean that you are a bad person. If you are truly overwhelmed by your debt and you do not see any way of overcoming it (and it certainly sounds as if you have been struggling and struggling with it), you need to look at credit counselling, credit proposals, or bankruptcy. I assume you are in the states, so I don’t know what exactly is available for you. However, in Canada there are three options under the bankruptcy act. First is an Orderly Payment of Debts — basically, your interest rate is reduced to 5%, and you pay off the debts in full within 4 or 8 years (depending on whether student loans are included in the debt total). This is arranged through credit counselling services. Second is a consumer proposal (perhaps not quite the right term) where you work with a bankruptcy trustee and propose to pay off all the debts at whatever rate — maybe 50 cents on the dollar. Finally, there is bankruptcy. Depending on the bankruptcy, I think you are bankrupt for a period between 9 months and 2 years, and during that time you get to keep the first $1700 or whatever of your take home pay, and 50% of everything above that is distributed to the creditors (I believe the cut off level is determined by family size). Some of your assets are protected (depending on province, you can keep a vehicle worth less than $5000, so much worth of food and clothes, I think professional tools for earning income etc etc — lots of information available online), the rest are liquidated and paid to creditors. If I were looking at debt that I could not repay within my working lifetime, even if I liquidated all my assets, I would be filing for bankruptcy. If your situation while living under bankruptcy is better than your current situation, that is a pretty big sign that it might be the right choice for you. Obviously, in an ideal situation you would be able to pay back everything in full without putting yourself into virtual slavery, but sometimes that does not happen. Bankruptcy and other remedies exist for a purpose — sometimes an individual needs that protection. I insure my vehicle and home. Hopefully nothing ever happens to them, but if I faced a catastrophe, then I would take the insurance money, even though that means I am being subsidized by all the other premium payers. In turn, I accept that my premiums subsidize those who have faced catastrophes. I feel the same way about interest. I don’t want every yahoo to claim bankruptcy and send my interest rates through the roof, but I recognize that my rates to some degree have to reflect the risk of non repayment by some debtors, and I can live with that when there is a case of true need or desperation in the other debtor.

    Truly, I wish you well in dealing with your situation.

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