28 comments

Springy Debt instead of a Cash Cushion

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.

 

  • Mr. Mustache's #1 Fan April 22, 2011, 11:11 am

    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.

    Reply
    • MMM April 24, 2011, 12:17 pm

      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.

      Reply
  • El Beardo Numero Uno April 25, 2011, 5:28 pm

    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

    Reply
    • MMM April 25, 2011, 5:52 pm

      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

      Reply
  • El Beardo Numero Uno April 25, 2011, 6:08 pm

    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

    Reply
    • MMM April 25, 2011, 8:57 pm

      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

      Reply
  • Chet February 6, 2012, 1:22 pm

    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?

    Reply
  • Warped April 26, 2012, 4:47 pm

    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

    Reply
  • Timo July 19, 2012, 3:31 pm

    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.

    Reply
    • AB September 25, 2013, 12:30 pm

      I’ve been considering a similar plan and wonder what MMM’s opinion is. I currently have $14k in student loans @ 6.5%. House is underwater so HELOC is not an option. I can take a 401(k) loan at 4.25%. Lower interest, but lost earning potential as well. Verdict?

      Related question – I’m sitting on $5k cash in savings as an emergency fund, plus a couple thousand for monthly expenses in checking. The wife doesn’t think the savings is enough; I see it being useful for eliminating the debt quicker. Keep the peace, or do the financially efficient thing?

      Reply
    • Joel June 20, 2014, 11:19 am

      I know this is going on 2 years later than your post, but a 401K loan is actually a pretty bad idea.

      The #1 scenario I can think of that would require tapping into an “emergency fund” (or credit fund in this case) would be losing your job, at which point the loan would become immediately due. If you don’t pay it, then it counts as an early withdrawal, then you’d have to pay income taxes PLUS 10% penalty.

      Reply
  • Double Down October 12, 2012, 3:26 pm

    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.

    Reply
  • Jason1 January 18, 2013, 11:42 am

    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)

    Reply
    • Mr. Money Mustache January 18, 2013, 4:44 pm

      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?

      Reply
      • Todd Carnes February 5, 2014, 6:26 pm

        You know. I like everything I’ve been reading here EXCEPT the credit card thing. There is no way in hell I would ever have another credit card and I do not for one minute believe there is ANYTHING good to be said about buying on credit.

        If you want to buy something. You either save up till you can pay for it in cash or you don’t buy it.

        Reply
        • JT June 4, 2014, 12:10 am

          Todd

          I agree. Have just paid off and cancelled my credit card. The world seems fairly intent on paying for things via credit though, so I’ve got a debit visa card for just those times. Saving up and making sure there’s money to cover purchases and groceries and mortgage/rent is the ONLY way for this little black duck!

          Reply
        • Mike September 28, 2014, 11:38 am

          How about saving up till you can pay for it in cash, then use the credit card to get the free airline miles/etc., then paying off the entire balance? Even with an annual fee, you end up better off this way in terms of cheap vacations etc.

          Reply
  • Calvin February 1, 2013, 2:19 pm

    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.

    Reply
    • Mr. Money Mustache February 1, 2013, 3:54 pm

      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!

      Reply
      • Calvin February 4, 2013, 8:33 am

        Thanks MMM! Looking forward to tackling the debt head on!

        Reply
  • Mark April 5, 2013, 7:41 am

    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.

    Reply
    • StraightStache April 11, 2013, 12:12 pm

      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.

      Reply
  • Nath June 17, 2013, 7:16 am

    Here’s an interesting way to make a cash cushion work for you: In Australia we have something called an offset account. It is basically a bank account linked to your mortgage. instead of “earning” you interest, the amount in the account offsets interest you are currently paying on the mortgage. Which is effectively a guaranteed 5.3% , and it is tax free as it is interest “saved” not earned.

    So my wife and I keep $100k in this account for emergencies or savings etc. similar results could be achieved by paying extra into your mortgage and then “redrawing” it later. If they allow this sort of thing in the states.

    The icing on the cake is this account we are using is on an investment property which has tax deductible interest also. The home we live in is owned outright…

    Reply
  • Logan September 16, 2013, 3:24 pm

    I have a bunch of debt that is inhibiting my ability to save and get ahead. I have a cash windfall coming up that I already plan to put towards eliminating debt. That said, I’ll still have some debt left over. I also have ~$5K in a retirement account. Not sure if you’ve covered this before, but would you recommend cashing out that retirement savings to help pay down debt? Thx in advance.

    Reply
    • DividendMan October 24, 2013, 9:38 pm

      Logan, that depends on the type of retirement account. Check what the penalties are for withdrawing money from your retirement account vs the interest on your debt and do the straight up calculation to make a decision.

      It’s very hard for me to find the logic in putting money into a 401k unless you are: 1) getting an employer match aka “free money”, 2) you are in a high marginal tax rate (in which case 5k shouldn’t be something to sweat over anyway).

      So, what this means is that you shouldn’t put money into a 401k unless 1) applies.

      Reply
  • Jill November 4, 2013, 2:19 pm

    Hi MMM! I’m an avid follower if YNAB and was introduced to your website via Jesse. This is article is totally eye opening to me. It’s very hard for me to imagine taking your advice, though. My situation is almost 28k in savings and one loan, a 48k mortgage at (ahem) 2.7%! I am currently not making extra payments because we are focusing on two things: saving for a down payment on a second home and applying for a home equity line of credit to purchase a rental property. Any thoughts on if we’re doing the best thing or should I actually consider paying off a large amount of our loan?

    Reply
  • Kristi G January 21, 2014, 12:48 pm

    Hi MMM! I am a new reader. I found you about a week ago and am working through your blog from the beginning. I hope you still read comments this far back!

    My husband and I are recently debt free after following Dave Ramsey’s program. The next step, per Dave, is to save up 3-6 months expenses and that is what we planned to do. First, we want to save up 5k to cover our new much higher insurance deductible. I gather from the comments that you would not recommend we do this, but I am wondering what your suggestion would be.

    For a little more detail: We own our home. We pay a mortgage on it but were able to build in a large amount of equity. We already live quite frugally (more so than you on some things) and our largest expense is gas. My husband currently has a 60+ mile commute one way 5 days a week. We are working on getting him closer to home which will free up a substantial amount of cash each month.

    The plan was for this cash to go into our savings for the next few years until we have our cushion, THEN we would begin to invest. What would you suggest?

    Thank you so much!
    Kristi G

    Reply
  • John B March 12, 2014, 5:08 pm

    Your springy debt concept is great for those who have the discipline. The problem is that the presence of and reliance on any credit card is a constant temptation to get in debt. I don’t think any one should even try the idea until they have all their basic savings in place at a minimum (no debts other than the mortgage, six months living expenses saved and accessible in case of emergency, and an ongoing habit of saving and investing.

    Love your blog BTW.

    Reply

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