Someone is in debt. They’ve finally decided to get their financial house in order. They have money to cover basic expenses. And a little extra each month. It’s one of THE hot debates in the financial community: pay off debt or emergency fund first?
They’re both worthy financial goals. And eventually, you’ll be out of debt AND have an emergency fund. But- right here and right now- which one should you prioritize? You can find the answer by looking at your particular financial situation, analyzing the type of debt, and looking at the pros and cons of each method.
Do you have a budget?
While both an emergency fund and debt pay off are admirable goals, it takes long-term persistence to do either. Even more than persistence, it takes consistently spending less than you are earning. Most people can’t (or don’t) do this without a budget.
A budget doesn’t need to be a strict “track every penny” method of life. Though I do advocate that method. To help you, I have an entirely FREE budgeting binder <<<click there to check it out. Or sign up below to get it delivered to your inbox.
The key to long-term financial health is simple: spend less than you make. Use the excess to pay off debt, fund an emergency fund, invest the difference. A budget is a useful tool for maintaining long-term progress.
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Are you planning for variable, but certain expenses?
What type of debt is it?
This is a key question that seems to get lost in the shuffle. Not all debt is bad. Well, it’s all bad. But some isn’t as bad as others.
- If it’s simply a mortgage, for God’s sake, build an emergency fund. Interest rates are generally pretty low on a mortgage and having the money there for an emergency is vital for long-term financial health.
- Student loans also have a fairly low interest rate. You can’t put an emergency on them. And they’re usually pretty large. In this case, building a small emergency fund and then tackling this debt is probably the way to go.
- Auto loans (usually) also have a fairly low interest rate. Unless you got ripped off. If you’re paying an exorbitant amount of interest, lump this in with credit card debt.
- Credit card debt is the worst. It’s money you’ve already spent that you didn’t have on stuff you probably don’t remember. And THIS is where the true debate comes in: build an emergency fund or pay off debt?
How stable is your lifestyle?
Before you decide whether paying down debt or an emergency fund is a priority for you, look at your particular financial situation. Which is unique and different from anyone else’s. You need to ask “how stable is my lifestyle?”.
Do you have a steady job? Or do you work freelance? If you work freelance and income is variable, having a larger emergency cushion might be a priority over throwing every cent at debt. On the other hand, if you have a steady job with no risk of layoffs, paying down debt might be the better choice for you.
Also look at how stable your expenses are. Are you young and in good health? Or is your health more fragile and unexpected medical bills might arise? If the former, you should lean towards paying off debt. If the latter, an emergency cushion might be the way to go.
Pay off debt first option...
Should I empty my savings to pay off credit card?
The argument behind the “pay off debt first” option is this: You’re going to put that emergency on your credit card anyways so save the money on interest.
A LOT of financial advisors advice getting a small emergency fund set up before paying off credit card debt. The problem with this logic? You’re probably going to put that emergency on your credit any ways. Yes (and for God’s sake, don’t start doing this), you can pay medical bills and rent with a credit card.
So you have- for example- $1,000 in a saving account earning maybe 2% interest (if you’re lucky…average savings account only earns on average .06%). While you have $1,000 in credit card debt getting charged 15%. Just take the $1,000 and put it on the credit card debt. That’s $130 (per year) you’re paying in interest that you could cancel. If you have a large emergency fund- say 6 months worth of expenses- and a crazy amount of consumer debt, the savings will be proportionally higher. (I read one story where the couple had $49,000 in emergency fund, but $60,000 in debt. I can’t even imagine the INTEREST on $60,000 a debt.).
Build an emergency fund first option...
The argument behind building an emergency fund is this: emergencies are going to happen. It’s part of life. The car breaks down (and you need the transportation to get to work). The heater in the house breaks (and it’s zero degrees outside). The cat decides to stop eating (and you don’t want it to starve to death). If you don’t have an emergency fund, you’re just going to rack up more debt.
Another concern: if you’re already maxed out on credit, there is no way to pay for that emergency.
How much money should I have in an emergency fund? That’s variable.
Dave Ramsey in particular is a bit psychotic about building up a $1,000 “baby” emergency fund before you start paying off debt. (In case you’re curious, after the baby emergency fund comes: pay off debt, build up real emergency fund, invest, college, pay off house, build wealth and give). I am an anomaly. I really don’t like Dave Ramsey. I’ve read one of his books. Browsed his website. And he’s mean. It’s his way or the highway. Maybe some people (clearly thousands love him) love the style of getting kicked in the pants to get your financial goals done. But I personally think encouragement and tough love work better than getting whacked over the head.
Do both option...
This method takes the most perseverance, but balances out the idea of an emergency and maximizing savings from interest payments. You’re not seeing hundreds build up a month in an emergency fund. Or debt disappearing like snow melting in spring. But if you do both, you’re covered for emergencies and your debt will get paid off.
As your emergency fund grows, you have a sense of peace knowing that you can tackle ever-larger emergencies. And once you get your debt paid off, you can fully fund the emergency fund with all that extra money. Eventually, you’ll start investing all that extra money!
It’s going to come down to your personal financial situation (how stable it is, the type of debt, etc.) and your personality.
If you know you’re going to get derailed off the train of paying down debt because a small emergency affected your debt repayment schedule, having an emergency fund is the way to go.
Mathematically- and if have drive- paying off debt first is the way to go.
Whichever way you go, I want to say “congratulations”. By doing either- and embracing spending less than you make- you’ve taken the first step towards building wealth.