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Thursday, August 4, 2011

First questions from a reader

Sarah from Bothell sent me some great questions that she'd like me to address.  These are questions I've heard a lot in workshops, possibly the first is the most common question.

Sarah: Which is more important, to build an emergency fund, or pay off debt first?  How much should you have for an emergency fund?

For the first part of this question I would like to give you a simple, formula answer for this, but honestly, the best answer is "It depends on each individual's situation".   The ideal situation would be both - pay down your debt while slowly building up your emergency fund.  But that is not always an option, especially when you're supporting a family or paying off a large debt like student loans. But let's come back to that because the second question is easier to answer.

Most experts will tell you to save three to six months of living expenses in your emergency fund.  I tend to go with the more conservative six months to a year.  But the minimum in your emergency fund should ideally be a minimum of three months living expenses.

As for paying down your debt vs. putting money away in an emergency fund, it really depends on what kind of debt you are talking about.   The first thing to look at is the interest rate on the debt.  Are you paying 13% on a credit card debt?  You should probably focus more on paying that off then because that high of an interest rate is quickly losing you money.  Are you talking about interest on a thirty year mortgage with a fixed interest rate in a neighborhood where the value of your home has increased and you have equity in your home?  Then you can safely focus on putting money into an emergency fund and keep paying your monthly mortgage payment.

Those are just two examples of the myriad of situations to take into account when you're asking whether to pay down debt or build up savings.   And no two individuals are going to have the same answer.

The best answer is, know your financial situation.  Know how much money you are spending each month to meet your needs, and know how much you're spending just for fun stuff.  Look at what your debt is and how much interest you are paying on that debt.  Look at what the debt is for - is it for a car that has depreciated in value (ie: is worth less than what you paid for it)? Or it is for a house that has appreciated in value (is worth more than what you paid for it)?  Write out an emergency plan for what you would do if you were injured and couldn't work for six months or lost your job and it took a year to find a new one. 

Sarah: Is there good debt?  How is a mortgage better or different from other types of debt?  What about a HELOC? Is that good or bad?

Let's start with the first question "Is there good debt?" In my opinion the answer is no.  Is there unavoidable-not-so-awful debt? Yes.  It is very rare that anyone can buy a house for cash these days in the U.S. so having a mortgage is unavoidable unless you are content to rent.  There are upsides to renting too, but you also don't get to enjoy the pluses of a good investment.  In this country is generally not considered a sign of good credit if you've never had debt and thus can't show you've paid it off, and even though I think that concept is completely wrong, it is a reality in our country.  So, some debt is hard to avoid, but definitely no, there is no such thing as good debt.  That is a myth.

I think I covered a little how a mortgage is better than some types of debt and that is because if you are working with a good real estate broker and you've studied up on where you are buying,  get a quality inspection of the real estate before buying and do your homework, chances are you are buying something that will increase in value.  There are other things you can buy that can increase in value too, but they are often not as necessary as a roof over your head.

My opinion on a HELOC?  It's generally a bad idea.  You're taking out a debt next to a debt.  Granted it's based on the equity you have in your house but that is all it is is equity.  It is not real cash.  It is a concept and you can't pay off debt with a concept.  And you already have a mortgage on your house, you are adding another debt to that - one that may or may not have a fixed interest rate.  Always look carefully at interest rates before taking out a loan.  Read the fine print.  Never assume that in ten years it won't matter when the interest rate is no longer fixed because anything could happen by then.  Look at the big picture and remember that ten, twenty, thirty years will someday arrive.  And you don't want your future self to be kicking your past self because your signed on to a huge loan whose interest rate shot up so much you can't pay it.

There definitely could be situations where a HELOC isn't a bad idea and could work.  But those situations are rare and for the most part people in this country don't need any more debt.

Sarah: How much of a mortgage is too much?  when does it become "bad" debt?

That's easy.  I actually have a one-size fits all answer to that question (finally!).  A mortgage is too much when it exceeds or comes close to exceeding the value of your home.   It is also too much if you can only pay your monthly payment as long as you don't lose your job.  The rule in our family is "If we can't pay our monthly mortgage payment while on unemployment benefits then our mortgage is too high."  That means it doesn't matter how much money we make, our mortgage payment has to stay well under $2,000 a month because I believe that that is the highest uninsurance benefits one can receive in our state.  And it has to stay below that because I doubt we'd qualify for that much if we lost our jobs.

That means that when we bought a house this year, we didn't get to buy that really nice little remodeled farmhouse on five acres with a barn and two pastures.  We had to buy a much cheaper house on a cul-de-sac with a small yard.  But we love it! We found what we could afford, it met our needs and as we settled in we realized is the best place for us.  Sometimes what you need to make you happy isn't what you *think* you need to make you happy.  And that's one of the biggest keys to staying out of debt.  Learn to enjoy what you *can* have and focus more on what you already have then what you think you want.

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