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Emergency Funds, Debt Payback Strategies, and Should You Invest or Pay Back Debt?

debt pay off investing pa-c Jun 22, 2022

You just landed your first PA job (congrats!), and are wondering what to start putting your hard-earned money towards. It is so tempting to use your new income on things that you have delayed purchasing while in PA school, such as a new car, fancy purse, new shoes, appliances, gadgets, toys, lavish vacations, etc. However, if you don’t formulate a plan, your money will easily disappear on those things, and in a few months, you will wonder where it all went. The question is, do you create an emergency fund, payback debt, or invest? All of these responsible areas are vying for your money’s attention, in addition to all of the fun things in life! If possible, try to work on an emergency fund AND payback debt AND invest. But how can you do all of that? Basic investing strategies will be reviewed separately in depth, but first let’s start with some of the basics of creating a plan for your income: emergency funds and paying back your debt. 

Emergency Funds

How much should you save in your emergency fund?

You will likely hear me say this multiple times, but it is a completely true statement: personal finance is personal, meaning that you need to decide what to prioritize in your life, which will help guide you to make financial decisions. The first thing to consider is the following: “How much of an emergency fund should I create?” To answer this, first ask yourself, “What would constitute a true financial emergency in my life?” Would it be something with a fairly large expense such as a medical emergency that prompted an ER visit, and then receiving a large medical bill that your medical insurance would not fully cover? Or would a financial emergency for you consist of something that is perhaps seemingly a smaller emergency to others such as getting a flat tire? It all depends on what stage you are at in your savings and journey to financial independence as well as your and your partner’s income. Second, ask yourself, “What amount of money do I feel like I need to have in cash or in my bank account to cover a true emergency?” This question should prompt you to think about how much money you truly need to be very “liquid”, or easily accessible. Often, if an emergency pops up, you likely could “float” some of the cost on a credit card, until you can get access to funds a few days later from accounts that are not very liquid. Please note: credit cards often carry high interest fees if you carry a balance, so definitely pay off the credit card ASAP. 

Personally, I think it’s reasonable to have about $1000, maybe up to $5000 in true liquid funds such as in your checking or saving account, or in physical cash. However, cash actually loses its value over time due to inflation, so it’s often best to not have a giant lump of money just sitting around. Again, this is a very personal decision. You may feel more comfortable and secure having a liquid emergency fund of a very high amount! The decision is completely yours after you have had the chance to discuss it with your significant other. 

After you have saved this initial amount in liquid funds, next decide how robust you would like your full emergency fund to be. The general advice in the financial community is to figure out what your minimal budget would need to be each month, then save 3 – 6 months’ worth of that monthly budget amount to complete your emergency fund. However, some chose to have 12 months’ worth saved in their emergency fund. Again, the decision is personal! 

So where should you keep the rest of your robust emergency fund? One option is to just let it sit in your regular checking or saving account through your regular bank; however, as previously mentioned, if your money is just sitting there, keep in mind that the interest you may earn from your bank is so minuscule that you would likely lose money to inflation over the years. Instead, consider something called a HYSA (high yield savings account). This is similar to a bank, but the money in there earns more interest than most banks.

Consider using your Roth IRA as (at least part of) your emergency fund.

If you do not mind if your emergency fund is a little less liquid, or at least a portion of it, consider investing it in a Roth IRA. Let’s first briefly review what a Roth IRA is. A Roth IRA is a tax-exempt retirement account that is for an individual, which means that the individual person (that’s you!) would open with your post-tax dollars to invest through. This means that it is not a retirement account offered through your employer. You would need to select the company / brokerage to open your Roth IRA through.

But wait, how can a retirement account be used as an emergency fund? I’m so glad you asked! How your Roth IRA can function as an emergency fund is that you can withdraw your Roth IRA contributions that you have made over the years tax and penalty free for any reason at any time. Think about it: you have already paid taxes on the money that you have contributed, so if you take it back out of the account, the government wouldn’t tax you again on it (that would just be greedy!). So, a portion of your emergency fund could be comprised of the contributions that you have made into your Roth IRA account, but not from the investment growth of the account. Of note, this brings up an excellent point: once you have opened your Roth IRA account, and transferred money into it, you need to ensure that you complete the next step to invest the money in the account! 

Although this is such a great emergency fund hack, it is important to note that withdrawing funds from your Roth IRA should only be done as a last resort in a true emergency. Why is that? Well, if you take money out of your Roth IRA to pay for the emergency, you are losing out to the potential compounding interest growth of the investments over the years. You always have to consider the opportunity cost of your financial decisions. Now that you have a plan to fund your emergency fund, let’s move on to figuring out how to optimize paying back all of your debt. 

Debt Payback Strategies

As a new PA, you very likely have a huge heaping pile of student loan debt. However, you may have other consumer debt as well such as a car payment, credit card debt, or debt from purchasing new toys and financing them in the process. So how do you manage paying back all of this debt? You need to make a plan to pay your debts off, otherwise you may make payments on your debt seemingly forever, and very likely accumulate more debt in the process. Let’s review two different debt payback strategies. 

Snowball Method: 

This concept has been popularized by one of the financial gurus that I’m sure many of you have heard of: Dave Ramsey. Before we discuss the snowball method, I would first like to say a brief word about Dave Ramsey. He has a lot of good advice that has helped many people get out of debt; however, there are some principles of his that many in the FI community completely disagree with. For example, he is completely against credit cards, whereas many in the FI community will strategically use credit cards to earn travel rewards to travel the world for close to free. I’ve heard some say that Dave Ramsey is like the gateway drug for the FI community, and I have to say that I love that analogy since it is hilarious and so true!

Getting back the the snowball method – what is it, and how does it work? First, make a list of all of your debts from the smallest amount to the highest amount of debt owed. The snowball method is essentially paying back your smallest debt first while continuing to make minimum payments on the rest of your debts. Then, once your smallest debt is paid off, you roll that payment amount that you had been paying for that debt towards the next smallest debt, and once that amount is paid back, you roll that amount towards your next smallest debt, and so on so that the debt payback continues to roll like a snowball would down a hill. 

The debt snowball method is ideal for those who need psychological “wins” while paying back debt, because with this method, you start to check off your debts one by one pretty quickly. However, it’s not as financially optimal compared to the debt avalanche method. 

Avalanche Method: 

The avalanche method differs from the snowball method in that you would write down all of your debts in order from the debt with the highest interest down to the debt with the lowest interest, then start paying back the debt with the highest interest rate first. Doing so makes the most sense mathematically because you will save more on the interest of your debt over time. However, you do not get the quicker psychological wins that the snowball method will give you. 

Which Method Should You Pick? 

Determine if you want to save more in interest over time with the avalanche method, or if you want to obtain more psychological wins more quickly with the snowball method. The bottom line is to choose a debt payback strategy and take action to implement it, but any high interest debt over 10% really should be paid off ASAP. Examples of high interest debts may be credit card debt (which usually have interest rates ranging somewhere between 15% – 25%!), payday loans, etc. The longer it takes you to pay off these debts with high interest rates, the more of your hard-earned money gets flushed down the toilet, figuratively speaking of course. Consider trying to pay back your debt aggressively by cutting back on expenses or wants and wishes, and by picking up more work either as a PA or other side jobs or even consider selling things around the home that you no longer use. 

Should You Pay Off Debt or Invest? 

The next question you may have is whether to pay off your debt or invest, or both with your extra funds. This is another personal decision! If you are very debt averse and hate carrying that debt with you, you may elect to put every extra penny towards your debt. However, if you don’t mind carrying some debt while investing, often doing both can be the mathematically better decision than just focusing on paying back your debt. 

Why can trying to invest at least some amount be a better decision than only paying back debt? The answer has two parts. 1) If you do not get your employer match in a retirement account such as a 401(k), 457(b), etc. if you’re offered one, then you’re leaving free money on the table. You should always at minimum get the match. 2) If you delay investing early in your career to focus on paying back debt, you’re missing out on the magic of compound interest. Compound interest needs time to build upon itself and increase in value over the years. Consider focusing on paying off high interest debt (for some, this is anything over 5%, and others may say anything over 8 - 10%) before putting extra funds towards your investments. 

We’ve reviewed emergency funds and debt payback strategies, as well as the importance of getting started with investing. In the future, we will review the types of investments that are usually suggested in the FI community as well as the order of operations for prioritizing the different types of investment accounts out there. 

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