Clear (agreed) overdraft or start emergency fund first?

Question

From what I have read, the general consensus is that it is best to set up an emergency fund first and foremost before beginning the process of clearing debt, regardless of how illogical that approach might seem at first glance.

It is often highlighted that setting up an emergency fund should take precedence above all else.

However, my question is this: what if you are in your agreed overdraft (negative balance, but within the agreed limit) before you begin starting said emergency fund?

Does that count as a debt? If so, should it be pushed to the back of your mind until the emergency fund is in place and then be addressed afterwards, or should it be cleared before starting to build an emergency fund?

Answer 1

The notion of an emergency fund before other debt-elimination measures is predicated on having made a budget that allows for saving money each month. Being overdrawn suggests that hasn't happened yet.

With most banks being frequently overdrawn is untenable as there are large NSF/OD fees and fees for being overdrawn a certain number of days, and the banks will start declining charges/returning checks leaving you unable to pay for things. That must be resolved before worrying about an emergency fund.

At other banks being overdrawn is less of an issue, some extend you a line of credit at a reasonable rate and spending is uninterrupted. This is how my bank works, if ever I were overdrawn there are no set fees, I'd just be charged interest at 13% annually. Even though this could be a lower rate than other debts, I would want to first get to a place where I am not consistently overdrawn before worrying about an emergency fund. The overdraft line of credit or low overdraft fees are basically serving as a stop-gap emergency fund already.

In either case you first want to get to a point where you aren't consistently overdrawn.

Answer 2

I think the consensus on having an emergency fund first is to keep you from breaking your budget for things like a $700 car repair.
So a small emergency fund first, just so you can keep your head above water as you work through your debt - without the emotional drain of having to use debt to get $700 to fix the car.

Then work on your debt

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if you are in your agreed overdraft

My answer assumes that your overdraft has a balance, and assumes that your balance (your debt) is not increasing each month.

If you are spending more than you make, you have to fix that first.

Answer 3

Why does having an emergency fund seem illogical to you? The idea of having an emergency fund is to cover short term, unexpected expenses, like car repairs or medical bills. I don't know what the "consensus" is about building an emergency fund vs paying off debt. There's a good psychological reason to build the emergency fund first: If every time such an emergency comes up you put it on a credit card, then you run your debts back up and you lose track of where you were in paying them down.

Personally, I would pay off credit card debt before seriously working on an emergency fund. As long as you manage the psychology, you can always throw an emergency expenditure on the credit card. That's not at all the same as paying off, say, a student loan or a mortgage.

If I pay off $1,000 on a credit card and then have a $600 emergency expense, so I run the card back up $600. I'm no worse off than I would have been if I had paid only $400 on the card, kept $600 in cash, and then used the $600 to pay the emergency. I'm probably better off, because by paying it off and then running it back up, I reduce my average daily balance and thus my interest charges.

On the other hand, suppose I pay off $1,000 on my mortgage and then have a $600 emergency expense. I can't put the $600 back on my mortgage. I might put it on a credit card. But the interest rate on a credit card is way higher than the interest rate on a mortgage. My credit cards have interest rates of 12% to 30%. My mortgage is 4%. Paying off $600 of a 4% debt and then adding $600 to a 30% debt is a big net loser. I would have been better to keep the cash so I could pay the $600 in cash.

I don't know what your bank's deal on overdrafts is, but fees on that are typically very high. You want to get that paid off and keep it off as quickly as possible.

Answer 4

First, if you have a prearrangement with the bank to provide you overdraft loans, then it's just a loan. It sounds like that's the arrangement you have, because I've never heard of a bank tolerating plain overdrafts every month.

Now just to disclaim this because it's important for others -- Without such an arrangement, overdraft is serious business. Now mind you, countries vary. But in the USA, where I sense OP is from, it needs to be covered right away, or it will be inferred that you intentionally wrote a bad check / did a charge you knew you didn't have the money to pay. That has consequences beyond fees. Least, they can close your account and place you in the ChexSystems blacklist -- and you will not be opening a bank account for 7 years. Lots of people become "unbanked" that way, which is a real problem if you're trying to create an emergency fund!

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That said, I disagree with my colleague that emergency funds are for people with budgets who already are living within their means. That would be to say that financial education is only for the already financially educated. Not at all.

Emergency funds are one way that you learn to live within your means. See any of the people who talk about paying yourself first. Taking a chunk of your paycheck and diverting it straightaway into emergency fund is a great way to avoid spending it some other way.

It's not like you spend the whole month hoping you have enough money at the end of the month, hoping you don't go to the bar too many times, or hoping you cancel the $150/month Comcast plan. You do those things because you have to, because you ran out of money, because you already diverted the money into the emergency fund at the top of the month.

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The reason to save for emergency fund first and not pay off debt first is the credit line won't be there for you when you need it. at the first sniff of you being in trouble, banks are quite aggressive about dropping $20,000 lines down to $500 credit limit for no reason, or dropping $29,000 lines with $11,000 balance to $11,200 credit limit. And don't be surprised when all your lines do it in the same month.

And, this can happen simply because the country is in a recession. The Great Recession saw a whole bunch of people's "credit card emergency fund" get erased before their eyes. I was listening to Suze Orman around that time, and it was an endless parade of tears.

Answer 5

First some terms.

The ultimate goal is two have two emergency funds:

• The larger fund is needed to cover 3-6 months of expenses if you have a period of unemployment or underemployment. This takes time to buildup, it can take years. So it is one that takes planning and diverting of funds from each paycheck to eventually reach that goal.

• The second one is referred to as a life happens fund. It is a small amount of money to cover the cost of an emergency car repair, appliance replacement, or a plane ticket for a funeral. Sure you can put these expenses on a credit card but the life happens fund takes care of the cost when the credit card bill is due. This fund is to pay for items that you have little to no advanced notice that you must spend the money on now. If you dip into the life happens fund you then spend a few months diverting money from each paycheck to replace the money.

People establish and fund these accounts while they are in debt. They do so while paying mortgages, car loans and student loans. In fact those obligations for those loans goes into the calculation of the size of the larger emergency fund.

There are different opinions regarding how to balance establishing these funds while paying off credit card debt. Those interest rates can be high, so it is hard to wrap your head around saving money at less than 1% while paying credit card debt at 24%.

You are in the situation of having an overdraft condition each month, when you get paid you get yourself above water, but every month you end up back in debt. You may also be paying fees for this overdraft. Your situation is similar to a person that has credit card debt but is also paying late fees, and over limit fees.

You need to start on the life happens fund. Because if you are hit with one of those emergencies you could exceed your overdraft limit. But to start on that fund you need to find away to not be in overdraft each month. You need a short term source of income, or a short term reduction in expenses. The income could be from a part-time job, or working overtime.

Once you are no longer regularly in your overdraft, then planning how to establish those funds can take place.