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How would you divy up some money?

  • All money should go towards the debt, NO savings at all, no emergency account.

    Votes: 10 38.5%
  • Split the money so that you have an emergency savings account.

    Votes: 16 61.5%

  • Total voters
    26
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Discussion Starter #1
I was taking a look yesterday at a budget worksheet yesterday on the Gail Vazoxlade site and it got me thinking. If you have debt (other than mortgage) why would you be putting money into savings? I'm thinking debt like LOC or CC's where you have a higher interest rate. My wife used to do this constantly when we first met, "I have $400 in my savings account!" but had $1000 on a Line of Credit.

link:
http://www.gailvazoxlade.com/resources/interactive_budget_worksheet.html

I'm trying to understand some reasoning behind it.
 

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The puzzling phenomenon of "debt diversification" is an area of interest for behavioural economists, too: I have a bunch of academic papers on this topic and last year I crunched a lot of data from the most recent U.S. Survey of Consumer Finances to look at interest rates and debt diversification for U.S. households.

The typical explanation I've seen for this is Kahneman and Thaler's notions of "mental accounts" - that is, that investors mentally separate their accounts into different "lock boxes" for different purposes.

So, for example, people set a financial goal to pay off their mortgage within 10 or 15 years, even if it means incurring other debts at higher interest rates along the way (or, conversely, people build up "emergency savings" which pay less in after-tax, after-inflation returns than simply paying off their mortgage would).
 

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Discussion Starter #4
I can see the emergency savings account being a good idea if you do not have access to a LOC at a low rate. Reason being if something did come up where you did need access to money quickly, you would have it. There are other items to consider here too, how good is your credit, and how likely would it be that a bank could just say that your LOC that you have been relying on is now closed.
 

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Discussion Starter #5
Making a budget in an Excel file is the FIRST step to get out of debt and live a healthy financial life.
The question isn't so much in regards to making a budget, it is in divvying up the funds that are left at the end of the budget. ;)
 

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I think the idea is to build up savings to avoid repeating the cycle. When you're dealing with people trying to get out of debt it's important to not go back into it.

As an example, there is very little advantage to aggressively pay off a credit card just to have to put a car repair on the card again because you didn't build savings. (Granted there would be some gain in the form of intrest savings)

Furthermore, It's a psychological boost seeing savings grow, and when an unexpected bill does come in, it's a good feeling knowing you don't have to turn to the credit card.
 

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It depends if you're a person who's sway by the psychology of money or not. I'm not. I'm grounded by the realities of where money is best used, and keeping things in order is the key to not getting swayed by the psychology of money. For example, keeping buckets of money targeted toward specific activities.
 

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A business prof once told me to be wary of businesses/companies with too little debt.

For the same reason I did not wait until I could pay cash to buy a home. Also unlike a company I am a mere mortal and want to enjoy some things sooner and with some health and time left.

I like borrowing to make money. I purchased $17K in stock on my HELOC and the yield (Please don't comment on which yield calc:) was just over 14% and the book value has increased by 33%. I saw an opportunity, had the credit and acted on it. However I am 'hit' with a borrowing cost of 3.75% (increased recently from 3.25%). I can enjoy this spread and am paying down the HELOC at my leisure. I am comfortable with the risk and, if for some reason could not carry the small debt, I would liquidate the investment (or an amount to cover the borrowed sum) and have a capital gain taxed. The dividend is from a Canadian company so taxed better than some.

Should everyone do this? Nope. I am I glad I did. Yup. Would i do it again? I intend to. Borrowing to save can be a very useful tool.

I own no GICs or Bonds.
 

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So, for example, people set a financial goal to pay off their mortgage within 10 or 15 years, even if it means incurring other debts at higher interest rates along the way (or, conversely, people build up "emergency savings" which pay less in after-tax, after-inflation returns than simply paying off their mortgage would).
That rings true to me. Very few people I know have a "total bottom line" mentality, and are perfectly comfortable with the idea that they might be losing opportunities to make more (or pay less in interest) as long as they're on their way toward meeting their various financial goals.

I do this to an extent myself: I use a TFSA for my emergency fund and I contributed the max to it last year and this year (and intend to continue doing so) even though my TFSA pays a considerably lower interest rate than I'm paying on my mortgage (which is my only debt). If I had a "total bottom line" mentality I would have applied that money toward paying down my mortgage, but it's important to me psychologically to have an emergency fund, and the TFSA is a good way for me to do it.

Another thing to consider is that (hopefully) debt will be paid off quickly whereas your savings could have decades to grow.
 

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I agree with Brad. An emergency fund is just that, an emergency fund, the money is there and safe, and if lose my job and my LOCs are cancelled, I can still live and keep paying my expenses and debts, at least for some time to find a new job.

With that funded, then the options for leverage investing and taking advantage of riskier investing options are open. It is psychological, I realize, but I feel risk taking is something I have to earn, otherwise I feel it's gambling, I'm not confident that my investment decisions will always pay off as even the best professionals in the industry don't always make money. Obviously, I'm not a gambler, but do I like to invest in things I believe will pay off. Pay off the mortgage, have an emergency fund, then you can play (even better if you have a pension plan!).

It's important to think of the additional risk taken to your life and whole portfolio for the after-tax spread between building an emergency fund, paying off the mortgage sooner, or investing the money somewhere else (with a best estimate of the risks/payoff profile in those investments). It's important to do the math, then you can have a clearer view of the risks you are psychologically willing to take or not.
 

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What is "the psychology of money"?
I think the psychology of money can be illustrated this way:

Start with the assumption that there is already a considerable gap between economic theory and observed economic behaviour in the real world. Then multiply that gap by 10 and you have the gap between economic theory and the behaviour of most individuals when making personal financial decisions.

It boils down to the fact that economic rationality plays a fairly small role in many personal finance decisions. There are many factors at play, both economic and non-economic, ranging from one's cash flow situation, one's education, one's risk tolerance, personal likes and dislikes, the need to please one's partner or at least maintain a state of domestic tranquility, one's degree of acquisitiveness or frugality, etc.

I'd go so far as to say that most personal finance decisions are ruled by psychology rather than any economic or financial principles. In business there's a somewhat stronger tendency toward rationality but psychology plays a role there too. And it plays a huge role in markets.
 

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My perspective is that emergency savings are all about liquidity. LOCs are quite liquid, so if you have plenty of assets that are less liquid (stocks, bonds, etc.), it is probably fine to have a small emergency account. I'd count this as the spare few grand in my chequing account. In the event of an emergency, you can draw on this fund/LOC in the short term while you raise cash from your less liquid assets. This is also my perspective on self-insuring against potential job loss. Six months income is an awful lot to have sitting in a savings account, quite unproductively, in the event that you might lose your job.

That said, since LOCs are callable, there is no guarantee you will always be able to draw on one. For this reason it makes sense to have some assets rather than dedicating all savings toward debt repayment. But for god's sake, don't keep $60k+ in a savings account wasting away.
 

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LOCs are quite liquid
I think it's important to draw a distinction between HELOC and other types of LOCs. The interest rate on a HELOC can be low, wheras the interest rate charged on a personal line of credit may not be much less than you'd pay on a credit card. I have a personal LOC with my bank that I had to set up temporarily to provide some extra cash when we bought our house, and I think the interest rate is something like 19%. I only used it once and paid it off in a couple of weeks; I certainly wouldn't want to rely on it as my emergency fund unless I were sure I could pay it off very quickly from other sources.
 

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Discussion Starter #15
I think it's important to draw a distinction between HELOC and other types of LOCs. The interest rate on a HELOC can be low, wheras the interest rate charged on a personal line of credit may not be much less than you'd pay on a credit card. I have a personal LOC with my bank that I had to set up temporarily to provide some extra cash when we bought our house, and I think the interest rate is something like 19%. I only used it once and paid it off in a couple of weeks; I certainly wouldn't want to rely on it as my emergency fund unless I were sure I could pay it off very quickly from other sources.
Our LOC is actually lower right now than our house!
LOC - 4.75(prime + 2)
mortgage - 5.4 fixed, 2 years left till it's done. oh how I wish I knew then what I know now...
 

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Im of the train of thought that I want to build up a decent sized savings buffer rather than pay off debt. But i only think this is because I am constantly toying with the idea of quitting my job and becoming a contractor.

Otherwise id ignore the buffer and pay down my debts.
 

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Discussion Starter #18
Im of the train of thought that I want to build up a decent sized savings buffer rather than pay off debt. But i only think this is because I am constantly toying with the idea of quitting my job and becoming a contractor.

Otherwise id ignore the buffer and pay down my debts.
Are your savings just in a high interest account? or is it invested in something gaining a bit more? What are your debts? Is it just a mortgage? or is it really low interest like some car financing?

To me this just sounds like you are paying money for money. Pay 5%, make 2% in interest, pay 40% of that 2% to tax... to make your actual interest income 1%... Now you are costing yourself 4% a year to have money in that account.
 

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The first poll response does not leave much leeway, as you almost always need at least a few thousand to cover expenses.

That being said, I've always viewed consumer debt and to a lesser extent mortgage debt as an emergency. What's the worst that can happen by throwing available money towards debt (which probably has an effective return of 7-30%) rather than an emergency fund (which will probably return about 2%)? If you keep your credit cards current, you can always use them for a small emergency, and then pay them off asap. What would constitute a bigger emergency? -- one spouse loosing their job? I contend that you will be better able to face that emergency with less debt, even if you have less of an emergency account.
 

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I think it's important to draw a distinction between HELOC and other types of LOCs. The interest rate on a HELOC can be low, wheras the interest rate charged on a personal line of credit may not be much less than you'd pay on a credit card. I have a personal LOC with my bank that I had to set up temporarily to provide some extra cash when we bought our house, and I think the interest rate is something like 19%. I only used it once and paid it off in a couple of weeks; I certainly wouldn't want to rely on it as my emergency fund unless I were sure I could pay it off very quickly from other sources.
PC Financial offers an unsecured LOC for Prime+3. Not cheap, compared to a HELOC, but not excessive. You probably need good credit to qualify.
 
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