Debt versus savings?

D-E-B-T: In the past year, it’s become an ugly, four-letter word and many people want to get out of it as quickly as possible.

However, Canadian households seem to end up even deeper in it — to a record high of $1.3 trillion dollars, according to a recent report from the Certified General Accountants Association of Canada. More than 40 per cent of people have seen their personal debt increase in the past three years, and 21 per cent of Canadians say they can no longer manage it.

Adding insult to injury is the fact that while Canadians are busy tackling debt, they’re neglecting other parts of their financial plans. Less money in savings means greater vulnerability if something goes wrong — like an illness, job loss or accident.

But if you have debt, should you concentrate on paying it off instead of building an emergency fund? This question has been keeping financial experts, advisors and personal finance bloggers busy for the last year. Here are some of the latest points to consider:

Conventional wisdom: Pay down that debt

If you’re carrying a lot of “bad debt” (e.g. high interest debt from credit cards), most experts agree that you should be paying it off first before building up your savings and investments. It simply doesn’t make sense to have savings that earn less than you’re paying out.

Consider: a $5000 credit card debt incurs a cost of more than 18 per cent interest a year — which means a monthly expense in addition to paying down the principle. Even when the economy was good, investments and savings didn’t return a yield that high. It therefore makes sense to get rid of the debt to eliminate the interest. Once it’s gone, both the money that would have paid the interest and the principle can go into a savings account or investment.

Even if you don’t have consumer debt, there’s still incentive to pay off the mortgage, line of credit or car loan early to potentially save thousands of dollars in interest.

However, by the old way of thinking if you didn’t have an emergency fund, there was no reason to worry. If worst came to worst, you could always charge the expenses to your credit card again or draw on your line of credit. You wouldn’t be much worse off than before you started, and you would have saved the interest in the meantime.

A return to old ways: Start saving again

While that strategy sounds obvious, the economy has changed some people’s way of thinking. With investments struggling to recover and “high interest” savings account paying very little interest, there seems to be even less incentive to save. However, setting aside an emergency fund is exactly what we should be doing, according to financial experts. Many have been touting the idea for decades — but now people are taking a second look at this advice even if it seems to fly in the face of current “common sense”.

In fact, financial guru Suze Orman caused quite a stir last March when she reversed her position regarding credit card payments. Instead of making debt repayment a priority, her new advice to readers is to only make the minimum payment on the debts and put every spare dollar into an emergency fund instead. Once the fund is up to par with a sizable chunk of cash, then people can return to their debt-reducing ways.

Why the change of heart? It’s more of a matter of strategy — on the part of banks and credit card companies, that is. Many credit card companies in the U.S. have raised interest rates, cut back credit limits and even cancelled accounts. With new credit card reforms due in the U.S. in 2010, consumer credit could get even tighter — even in Canada.

In addition, banks aren’t so quick to lend money these days. With homes worth less than before, the equity may not be there. Besides, a job loss or serious illness is unlikely to persuade them to give you a loan.

In other words, people who count on credit cards or loans to see them through an emergency could find those resources suddenly unavailable. With no back-up plan, that means incurring new high interest debts or cashing in investments — often at a loss and with a penalty.

The new advice is to therefore set aside money just for emergencies. It’s not for a vacation or a new TV, or even for long-term investments like an RRSP. Experts recommend putting your emergency fund in some sort of investment vehicle where your principle is guaranteed — and you’ll earn a little interest too. The important thing is the ability to access it when you need it without an early-withdrawal fee.

Your emergency fund — how much?

Most experts agree that you need one, but what they can’t agree on is how much. Some experts recommend saving the equivalent of three to six months worth of income. That amount would cover most contingencies — like an unexpected home or car repair or a job loss.

Other experts like Dave Ramsey suggest a more conservative amount: three to six months worth of expenses (rather than income). Orman recommends eight months, and some experts recommend up to a year if possible. If you’re living below your means, you won’t need as much cash to cover you. “Wants” like trips, eating out or RRSP contributions shouldn’t come from your emergency reserve — they can wait until the crisis has passed.

Still think this number sounds too high? Many financial experts would still agree with you. Some argue that as little as $1000 – $3000 — which was what many people were recommending before the recession — still provides enough of a cushion.

These are only estimates. How much you need to set aside can depend on any number of factors, including:

– Job security. Are you in an industry that’s particularly volatile, or a in a field where jobs are harder to come by? With many people losing jobs — and finding it harder to find new ones — there’s even more reason to aim higher to cover the months in between.

– Whether you own your own home or rent. In general, people who own their homes mortgage-free can ease off a little because they’re not worrying about monthly payments. In additions, home owners do have to worry about unexpected repairs and replacing appliances, whereas renters generally don’t. However, renters should keep money on hand for a new security deposit if they have to move.

– How much insurance you have. Your emergency fund should cover what your insurance and benefits don’t, including your deductibles.

– Your dependents. You may need a little extra room if you have children or parents relying on you for financial help.

– You have pets. An accident or illness shouldn’t put you into debt, or force you to make a difficult decision.

– Personal circumstances. Health, other financial goals, marital status and other factors you may want to consider, if they apply.

Experts note you don’t have to build an emergency fund all at once (as little as $50 – $100 per month makes a good start). In fact, some experts recommend a “tiered approach” so you can maintain some balance in the books. For instance, Dave Ramsey’s “baby steps” approach starts with setting aside a “rainy-day” fund of $1000 before tackling the debt. Once the debt is gone, the emergency fund is built up before extra money is put into retirement savings.

If that still sounds too high, take expert Gail Vaz-Oxlade’s advice and start with a goal as small as $500 for a “Ways-and-Means” fund. Even small financial fixes like trimming your grocery budget or skipping meals out can supply a little extra cash for this purpose.

Ultimately, only you (and your family) can determine how much of a buffer you’re comfortable with. The goal isn’t to provide yet another expense to already-stretched budgets, but to make sure there’s some provision in case of emergencies.

ON THE WEB

Emergency funds have been widely discussed in the media and in blogs. Here are a few sources for more information:

– Read Suze Orman’s advice on credit cards versus emergency funds: New Credit Card Strategy.

– DaveRamsey.com has a wide variety of tools and advice.

– Personal finance blog Get Rich Slowly has a good overview of emergency funds here.

– See Canadian expert Gail Vaz-Oxlade’s advice on emergency funds.

Additional source: The Zoomer Report: Household Debt.

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