According to the National Foundation for Credit Counseling, nearly two-thirds of Americans can't come up with $1,000 in cash to handle an emergency expense. Instead, they'd be forced to borrow money to cover that cost, often at the extremely high interest rates implied by cash advances or payday loans.
That's a huge problem, as it means that far too many people are in a situation where a minor fender bender could knock them out for years. After all, if you need to borrow money to come up with the cash for the repairs, then you'll not only be paying for the repairs, but also interest on the borrowed money. The interest could turn what would have been a minor incident into an expensive, multi-decade headache.
Back away from the ledge
Standard financial advice recommends an emergency fund with three to six months of living expenses in it. That might seem like a pipe dream to those with less than $1,000 to their names, but it is very prudent advice, especially in a time of high unemployment. While you should strive to get to that level, there's no law pushing you to get there immediately.
In addition, it makes absolutely no sense to have a six-month emergency fund earning just about 0% while simultaneously paying 20% or more in interest on credit card debts. As a result, any emergency fund needs to be part of your overall cash management plan. You can get there, but you need to be smart about it. Here's a simple, four-step plan to take you from debtor to investor, including that well-stocked emergency fund:
Step 1: Pay off any extremelyhigh-cost debts . If you're paying more than 24% a year -- about 2% per month -- on any debts, take any spare cash you come across and pay those off before worrying about an emergency fund at all. This includes payday loans as well as credit cards.
Seriously -- those payday lenders rake in some mighty fine cash from those who can't get money any other way. Payday lender Advance America ( AEA ) picked up more than $140 million in revenue last quarter. And it's not alone. Cash America ( CSH ) collected more than $132 million from consumer loan fees, and QC Holdings ' payday loan business raked in better than $28 million in revenue, over the same period.
All three of those companies are profitable and pay dividends. When all is said and done, which side of their operations would you rather be on: The side paying the fees or the side collecting the dividends generated by those fees?
Step 2: Sock away that first $1,000 miniature emergency fund . Yes, if you've got other debts, you'll likely be paying more in interest on those debts than you'll be making on that $1,000, but that can be OK. The point of that fund is twofold. First, it helps you prove to yourself that you can save money, even if you've never been able to before. And second, it's an insurance policy against having to take out even higher cost debt because of a small, unexpected cost.
Step 3: Pay off any other non-value-added debts and other high-interest debts (like ordinary credit cards) as well. In essence, if it's not keeping a roof over your head (mortgage) or enabling you to get a higher paying job (school loan), it's probably not a debt worth carrying. And even then, if the rates are much above what you can earn on your savings, you might still want to pay off or refinance those loans, as well.
While credit card costs aren't typically as high as payday loans, they often carry double-digit interest charges along with them. Partly, that's to assure healthy profits for the lenders, but it's also partially due to the charge-offs of hopelessly delinquent loans those lenders have to cover.
Discover Financial ( DFS ) had total charge-offs of more than $730 million in its last quarter, and Bank of America 's( BAC ) card services had $481 million provided for potential card losses. Even American Express ( AXP ) , whose charge-card-centric model encourages prompt payment, has been writing off about 3.4% of the amount charged on its cards. That money has to be made up somewhere, and it largely comes from those who do pay their bills over time.
Step 4: Save the rest of your emergency fund and start investing .
How to make it work
As simple as that four-step plan sounds, before you even get started, you'll need to get in control of your overall spending. Make a budget that lets you prioritize what you really need , and cut back on everything else until you're able easily cover today's costs of living on your salary, with money left over. Once you set that budget, pay yourself first by putting every dime you earn above and beyond that budget toward your four-step plan.
It takes discipline. It takes sacrifice. And it takes time. But with all three, nearly anyone can become financially secure. That's a much better place to be than living paycheck to paycheck with less than $1,000 separating you from financial devastation.
At the time of publication, Fool contributorChuck Salettaowned shares of Discover Financial, Bank of America, and American Express. The Fool owns shares of and has opened a short position on Bank of America.Motley Fool newsletter serviceshave recommended buying shares of Discover Financial Services. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.
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