Springy Debt instead of a Cash Cushion
Good morning readers, and Happy Earth Day!
I’m supposed to be packing for a MMM family camping trip, but I thought I’d post this question that came over the wire to Mustache Headquarters late last night. After that, I may or may not be posting any updates until Tuesday, April 26th or so.
Q: Mr. Money Mustache,
I was curious where you stood on the subject of building up a 6 month savings cushion versus flinging money at existing debt? I know what Dave Ramsay says, but I also value Mr. Money Mustache’s experienced opinion. Thanks!
A: SOME sort of cushion, or ‘stash as we refer to it here, is essential to keep your life smooth even in the event of losing a job or having a big unexpected expense. But it is a huge waste of money to keep money in the bank earning no interest, while paying higher interest on debts.
The solution I like to use is “springy debt”. That is, debt that you can pay off or withdraw from, at will. A credit card is one form of springy debt. A mortgage, on the other hand, is one-way debt, since you can pay extra on the principal, but never suck money back out when needed.
I always set up a line of credit on whatever house I’m living in, and keep its balance at zero whenever possible. And I keep very little money in real cash in the bank – just a few thousand dollars, enough to cover a month or so of spending. Credit cards are automatically paid in full from this account, so it has to safely cover that without going into the red.
Any unpredictable expenses that aren’t covered by the bank account can now come straight out of the line of credit! Most people can qualify for a line of credit big enough for quite a few months of emergency expenses.
Some fancy bank accounts even let you connect a line of credit directly to your bank account. This is even more convenient, as long as the interest rate is still close to the prime rate.
If people currently have unpaid credit card debt, this is much more of an emergency. You DEFINITELY don’t want a cash cushion in this case, because the credit card is already an expensive cash cushion running in the negative. In this case, I’d keep paying off the credit card, and if possible get a line of credit on your house to pay off the credit cards, and then pay the line of credit down to increase your safety margin. And of course, cut spending drastically since unpaid credit cards mean you are walking very close to the edge of a steep cliff!
There will be lots of more detailed posts on dealing with debt in the future, since a lot of Junior Mustaches might be starting out with uncomfortable levels of the stuff.
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Mr. Money Mustache is a family man living in the United States who retired from work, relatively wealthy, at about age 30. After several years of retirement, he noticed that his still-working peers were envious of his lifestyle. They were making more money than he ever had, yet they were somehow still broke. So he decided to write this blog to educate the world on how it is done.
Am I getting ahead of myself to ask where Mr. Mustache is “stashing” the bulk of his money then? This junior mustache has no credit card debt or car loans. Just a mortgage, equity line, and six figure student loans. Oh and a husband (with a worst case scenario mentality) who is adamant that a 6 month “stash” is necessary before anything else. I kinda think the home equity line should go first, even before replacing the car. Either way, we are currently doing a thorough (and painstaking) review of our finances to see where we are spending our money and because I need to know exactly what 6 months of expenses amount to.
Hi #1.
I’ll answer your second question first: It is great that you have already established a home equity line of credit. Is it already maxed out? Or is there room on it for more withdrawals as needed? Either way, this would work great as your emergency ‘stash. Just pay it down using any and all available money and that is increasing your safety cushion, while simultaneously increasing your monthly free cash since your interest costs go down as you pay it off. You’ll be slowing down the backwards-moving conveyor belt that is currently fighting your efforts.
As for the student loan – is it at a higher interest rate than the line of credit? If so, you’d probably want to put extra payments towards that once you get your line of credit paid off to a safe level.
So I see no value in having any real cash savings beyond that available for the line of credit. It’s like saving up rainwater for future firefighting when there’s a brushfire currently burning in your backyard. If anyone has arguments to the contrary, send them in a comment – I am interested!
And as for the the MMM family – we still have a bit of leftover balance on a home equity line of credit so we’re finishing that off before resuming payments into index funds like the Vanguard S&P 500 Index fund (VFINX). Also, we don’t earn much these days so there isn’t much saving to be done – minimal part-time income and passive income from investments just pays for our low-cost but nice lifestyle.
Senor Moustache,
I am wondering, for your fellow financial pogonotrophists who do not have houses or mortgages, what financial instrument do you recommend for a springy buffer?
I currently have 6 month’s worth of little employees idling about in a savings account, and I’d really like to put them to work. I’m paying low rent, quickly paying off student loans, and saving a fair amount.
I’ve considered a High Yield Checking account, but I’m not sure I’ll be able to maintain my buffer with all of the mandatory direct deposits & debit card purchases per month.
Your Compadre,
EBNU
Estimado Sr. Uno,
Thanks for bringing in some new perspective – indeed many of the most promising Junior Mustaches may be renting a place at the moment and thus unable to set up a home equity line of credit. Like you, I would still feel a little inefficient by keeping 6 months of employees idle. But your strategy will vary depending on your situation:
- How secure is your job and your industry in general? If things are pretty rosy, you could go for a smaller cushion and put the rest directly into the student loan to speed up the payoff even more.
- Remember that a credit card is already a good safety cushion for very-short-term expenses. As long as there is no chance of not being able to pay off the balance in full at the end of the month.
- And to REALLY answer your question, I think you might be interested in an “unsecured line of credit”, also called a “personal line of credit”. I just reviewed the current offerings on lendingtree.com. The interest rates are fairly sucky – ranging from 6.78% to 10%+, but remember you are very unlikely to ever use this line of credit. A local credit union might also offer good service and rates.
If you can get approved, set yourself up with a personal line for about 6 months’ worth of expenses, and then blast 4 months of your current savings into your highest interest student loan. Then you’re effectively getting a return equal to your student loan interest rate. (what are the rates on those things these days, anyway?).
best of luck,
MMM
Senor Moustache,
My job & industry are very secure, so I may go for a lower cushion – just enough to cover any slip-ups in cash-flow forecasting, for example.
I just realized I could put the rest of my cushion in my Vanguard account, where my long-term savings is hard at work. It takes a couple of days to get the money back out, and there are tax implications, but I could cover any short-term emergencies with credit cards.
Or, as you mentioned, I could put most of the cushion into the student loan, and just rely on my current long-term savings as a cushion.
I consolidated my student loans at an unfortunate time, and I’m paying 7% (ouch). Right now I’m distributing 75% of my “savings” into my loan, and 25% into long-term savings. I figure the 7% “return” on my loans is pretty good, and the emotional payoff of becoming debt-free is a priority for me. What are your thoughts?
Muchos gracias for your excellent blog!
-EBNU
Ahh, you’re further ahead than I thought – you are already hooked up with Vanguard! I am also a long-time Vanguard index fund fan and I think it is good to put a certain percentage of your savings in there consistently. When I was younger, I used to put Everything in Vanguard and just let the mortgage do its slow auto-payment thing (figuring stock market returns should beat mortgage costs on average). But now I am more interested in the emotional peace of absolutely no debt so I’m finishing off the last bit of mortgage before resuming index funds.
Also, with this being a new blog and all, I’m going for a simple message before branching off into different strategies for all different types of people.
thanks again for your comments!
MMM
I am 24 and trying to save as much as I can for a downpayment on a house right now. I have about $12,000 saved up towards this goal and some more money as an emergency fund but it is all currently just sitting in my bank account. I am still a year or two away from seriously considering buying, in the meantime where would you suggest keeping this money to work for me while I wait?
I have a Vanguard Roth IRA that I max out every year, is there another Vanguard service you would recommend?
Chet,
Since you are planning on using the money in 1-2 years, I wouldn’t put it into stocks, or even bonds.
Some might put it in something like short term treasuries, but you risk losing some and the upside is fairly small.
Personally, I’d move it to a savings account at ING; you’ll earn maybe $100 but won’t lose any; stocks can and have gone down 50% in one year – good place for long term money, bad for 1-2 year money.
JMHO
So here’s a question for you: Springy debt sounds great, but due to the nature of the real estate market right now, I have negative equity on my condo. This means that a HELOC is out of order.
Which got me thinking: For springy debt, what’s MMM’s take on using a 401k loan? The rate is pretty low (prime +1), and with an upper cap of $50k that should be more than fine for short term emergencies.
Thank You Mr. Money Mustache for teaching an old dog new tricks.
By following your advice from this post, I estimate you just saved/earned me $18,386 over ten years by moving money out of my lame bank account (“gotta have at least 3-6 months salary in liquidity for emergencies!”) and towards paying off debt instead, while relying on our HELOC for emergencies*. FWIW, your slightly more aggressive figure of multiplying by 177 for a ten-year return resulted in a calculated savings of $21,243. Either way, it’s close to one year’s worth of college tuition and expenses for a daughter!
*Okay, in reality I would not have been carrying this debt for anywhere near 10 years, but the point still is that I will be putting the money to work — if not paying off debt, then elsewhere — and far better than the bank rate of 0.000001% or whatever it is.
I believe the original questioner didn’t quite understand Dave Ramsey’s plan. I have been listening to Dave for years and he doesn’t say to have 6 months expenses if you have debt. His “baby step” plan is step 1. 1,000 in the bank as a “baby” emergency fund. step 2 is pay off all debts but the house. Step 3 is 3-6 months expenses. The key with his plan is the range of cushion. Some people have more stability and may only need 3 months. Some people have a more volitile life, job, etc. and need 6 months to feel comfortable.
Love your website, great tips on frugal living but i do disagree with just a few things, mainly use of credit cards and helocs (even if you pay them off every month)
Thanks for the clarification, I admit to not knowing the finer points of the Dave Ramsey plan.
But foregoing credit cards and low-interest financial leveraging for investments and/or emergency fund? That is crazy talk! .. I suppose if you are still in the stage where you are subject to impulse purchases, it’s a fine way to try to limit the damage you do to yourself. But at the Mustachian levels of self-awareness that we are talking about on this blog, the method of payment would have absolutely no effect on a person’s spending. A purchase should be based on your values, and your financial situation – that’s it.
Thus, a credit card is just a way to get a 1-2% discount on everything you buy, with no drawbacks. Where is the problem with that?
Alright– I respectfully request clarification on the strategy of leveraging cash on hand via line of credit to pay down student debt as mentioned above. My current understanding and situation are as follows:
I have a $25k emergency fund in my checking and $79k in student loans (putting extra $800 towards principal monthly). Are you suggesting I take out a line of credit to replace my cushion and apply the cash towards debt?
So, If I lost my job for 2 months, for example, I would then rely on the line of credit to cover expenses until I get another job and am able to cover expenses again? Then, I would have 2 month’s worth of expenses as debt that is accruing interest and becomes the primary focus of all extra money until eliminated?
This strategy would drastically reduce my debt principal, increase amount of payment that goes to principal rather than interest, and shorten time until loan is eliminated and total amount of interest paid, correct?
And the risk of employing this strategy is the potential of having to pay interest on two months worth of expenses? So, the less the chance of me needing the line of credit the safer it is to use?
Also, lines of credit do not have the grace period that credit cards do, correct? So, if I draw $1000 and repay it before the next “billing cycle” ends I would still pay interest on it, correct?
Thanks for your time and the blog! I think I am beginning to see some peach fuzz developing on my upper lip as I continue digesting your wise ways. Much appreciated.
Hi Calvin – YES on all counts – I’d definitely dump that HUGE emergency fund into the student loans, as long as you have a nice open line of credit with the checkbook and debit card in hand and ready to use.
I’ve never had anywhere close to $25k in cash in my life, except just before buying houses when it was needed for the downpayment.. and still don’t keep that much even today!
Thanks MMM! Looking forward to tackling the debt head on!
Thanks for all the hard work on this blog. I just discovered it and like what you have to say. A question: where do you save the money for a new to me car? I just changed jobs, but think I will be able to save 200 per month, but that means I have the cash for 4-5years before I need it (unless a transmission goes out, as just happened, but another story). Where should the pool of up to 10k go? CDs? Money market? Thanks.
Mark,
Bonds produce decent returns in 4-5 years. In your case I would split the savings between a high interest savings account and bonds. It’s always good to diversify. Be careful of fees when you’re getting bonds though. It would eat into your return quickly if you are having to pay fees often. Some places will waive fees if you have an automatic investment. I would start moving the money out of bonds as the time to buy the car approaches.