Wednesday, December 22, 2010

E-fund Vs. Debt Snowball

Personal finance authors and bloggers have all written their version of E-Fund Vs. Debt Snowball. And each one of them has their own recommendation of which to focus on. Saying you have an unexpected lump sum, or some magic jar money left over, would you be more likely to deposit it in your e-fund or apply it to your debt snowball?

Each of these methods have merit.

Emergency funds are an important part of personal finance. It's your safety net when ka-ka hits the fan, like an unxpected fender bender in the mall parking lot. Your insurance will likely cover the repairs and maybe a rental, but you have to come up with the deductible. You haven't put that in your monthly spending plan. So you turn to your E-fund. Problem solved easily.

You could be getting a layoff notice from your place of employment. It could take months before you are offered another job that is comparable to your last one. But your rent still needs to be paid, as do the utilities, and you still have to put food on the table. Again, you turn to your emergency fund. There should be enough money in there to last you for several months with your regular expenses. If you tighten your belts and cut down to the bare bones budget, perhaps there will be enough to last you for maybe even a year.

Some folks, like Ramsey, endorse having a 'baby' Emergency fund of $1000. Somehow, having only a thousand dollars should cover some, most or all of an emergency that arises. I guess knowing the difference between a real emergency and a spending emeregency helps too.

Snowballing your debt payments is a method largely endorsed by Dave Ramsey. To use this method, one would list their debts by amount, smallest to largest. Making only minimum payments on all other debts, focusing on the smallest debt first. Aggresively pay that one off, and them apply the payments toward debt #2. It works for folks who need to see that their efforts are making a difference.

Another 'snowballing' method that is endorsed by Gail Vaz-Oxlade (and others) is to attack your highest interest-rate debt first. By applying all your 'extra' money to the debt with the highest interest-rate, and maintaining minimum payments on all the rest, you reduce the overall amount you have to pay out. Mathematically, this would be the better choice to use.

For most of us, we fall somewhere in the middle. We don't have a fully funded Emergency Fund yet, and we still have debt to pay off. For our household, we find our balance somwhere in the middle. Before we spend any money on anything, we put 'something' into our Emergency Fund, even if it's only $20. Then we pay our living expenses and debt payments. After that, we put money into our various saving pots: RRSP, Vacation, Xmas, E-fund (again), Kids College funds, Automobile savings, etc. Some of the numbers we are dealing with are overwhelming, like amount to save for retirement and E-fund. Others are more specific and manageable, like Xmas account. But we try to put some in each one every month.

In our house, we also follow the advice of paying down the highest interest-rate debt first. This has been our focus. All debt is not created equal, and in some circumstances, it's more important to pay down one debt over another, due to terms and such. Not all of our debt is consumer debt. Some is taxes owing, which is in a whole different realm altogether.

We are seeing the difference our efforts are making. Every month, the balances go down, and occassionaly we get a 'win' by being able to completely focus on one debt to pay it off. This past year, our debt has risen again, due to unforseen bills (completely our fault), and owing income tax (which I should have known about,but didn't). Hopefully, in the coming year, an increase in business income should help us to really make a dent in our debt. Now just to keep it down.

1 comment:

  1. Great resource, I haven’t seen that one before. I like to do a written plan for my debt instead of using the computer. Just works better for me.