As you take charge of your finances, you’re making plans to improve your money situation.
Up next on your list may be a tricky decision:
Should you focus on paying off debt or should you work on building a solid emergency fund?
To be fair, both options are steps in the right direction, which is why you might find it difficult to choose between the two.
Learn about the benefits of each approach to find out which one is the smarter move for your finances.
Why You Might Prefer to Pay Down Debt
There are a few reasons you would want to focus on paying down debt.
Reduce interest paid
Borrowing money isn’t free, you have to compensate the person or bank that loans you money for the risk they’re taking. This compensation comes in the form of interest payments.
Interest is represented as a percentage of your loan’s balance per year. Consider this simplified example:
You borrow $10,000 at an interest rate of 5%. You don’t make any payments in the first year. At the end of the year, you will owe $10,500 to the bank you borrowed money from the $10,000 you borrowed and $500 in interest.
Different types of loans have different interest rates. Your credit score also plays a major role in determining the interest rate you pay. In general, riskier loans have higher rates.
That’s why credit card debts and personal loans, which have nothing backing them, charge more interest than a mortgage or car loans, which are secured by an asset.
People with poor credit also pay more interest than people with good credit.
If you pay down your loan’s balance, the amount of interest that accumulates is decreased.
Making larger than required payments reduces both the length of time it takes to pay off a loan and the amount of interest you will pay.
You have $100,000 in student debt at 6% interest. The loan has a term of 20 years, so you will make payments every month for the next 240 months.
If you follow the loan’s schedule, you’ll make monthly payments of $716.43.
After 20 years, you’ll have paid a total of $171,943.45. By making the minimum payment, you’ll have paid more than $70,000 in interest.
If you up your monthly payment to an even $800, you can save a huge amount of money. Instead of taking 240 months to pay off your loan, you’ll take 197 months.
You’ll be debt-free more than 3 years sooner.
Even better, you’ll only pay $57,324.69 in interest, which means you save more than $13,000 by focusing on paying down your debt.
Peace of mind
Don’t discount the psychological value that paying down your debt can have.
You’re constantly worrying about paying a bill that doesn’t seem to go away.
Your relationships may suffer because of the financial strain that is caused by debt.
The truth is:
If you don’t make those payments, debt collectors will hound you and your credit score will drop.
If you do make the payments, you might not have enough to make ends meet or buy the things that you want.
Being debt-free means you have more money available to save or spend as you’d like. It also means less stress as you worry about handling all your bills or accidentally missing a payment.
Why You Might Focus on an Emergency Fund
There are some good arguments in favor of building an emergency fund before you focus on paying down your debt.
Avoid new debt
One major benefit of having an emergency fund is avoiding new debt.
If you don’t have any money in a savings account and your car breaks down, you have two options:
- lose your job because you don’t have a way to get to work, or
- take out a loan to pay for car repairs.
The choice is clear:
You should take out the loan so you can continue earning an income to pay your other bills.
Still, borrowing money isn’t free, so you’ll have to pay interest on the loan.
If you had money in an emergency fund, you could instead pay for the repairs out of pocket. You would have to replenish your savings, but you wouldn’t be dealing with interest charges while you do.
How much to save
How much to put in your emergency fund is a difficult question because there’s no one size fits all answer.
The answer depends on your situation: how many dependents you have, how secure your job is, whether you have a social safety net.
A good rule of thumb:
Aim to have between 3 and 6 months’ expenses in your emergency fund.
This is enough to pay for most emergencies and to help you cover your living expenses if you lose your job and have to find a new one.
Which One to Prioritize?
Now that valid reasons have been presented to you for consideration, you clearly see the benefits of paying off debt and building an emergency fund.
That being said:
You don’t have to pick one over the other.
Rather, you can address both goals simultaneously.
Start with a small emergency fund
The best thing to do is to focus on building an emergency fund first.
This can be difficult, especially if you have high-interest debt, but this safety net of accessible cash is hard to beat.
If you have no emergency fund, one unexpected expense could force you into taking out another loan which will only add to your pile of debt.
You don’t want to find yourself in a situation where you already have so much debt that you can’t borrow more money. (Or, you’re stuck with very expensive, high-APR loans.)
Split your focus
Consider is to split your money between an emergency fund and high-interest debt.
Start by putting 100% of your focus on building a small emergency fund of about $1,000.
Once that has been achieved…
Split your attention between increasing that emergency fund and paying down any high-interest debt.
Once you’ve paid down your most expensive loans, you can start to split your extra money between your emergency fund and your remaining debts. Once you’ve built your savings to the point where you’re comfortable, you can fully focus on paying down debt.
Consider Consolidating Your Debt
If you have multiple loans or even just some high-interest debt, you can benefit from consolidating your debt.
Debt consolidation is the process of taking out a new loan and using the money to pay off your old loans.
This lets you change your debt’s interest rate and lets you combine all of your monthly bills into one monthly bill. You can also choose the term of your new loan when you consolidate your debt, giving yourself more time to pay off your loans.
There are two good ways to consolidate your debt.
Personal loans are some of the most flexible loans on the market.
You can use a personal loan for nearly any purpose, including debt consolidation.
Many lenders offer personal loans. Some specialize in small loans while others will let you borrow as much as $100,000 or more. You should have no trouble finding a personal loan that will let you consolidate your debt.
Personal loans are also great for people who need to get money quickly. If you want to consolidate your loans and only have a few days to do it, personal loans are the way to go.
Balance transfer credit card
Balance transfer credit cards are another good way to consolidate your debt.
If you can commit to paying off your debt quickly, they can help you save a lot of money.
Many credit card issuers offer incentives to customers who sign up for their credit cards. One of the most common incentives is a balance transfer deal.
Usually, there’s an introductory period where the balance transferred will enjoy a 0% APR — this means you don’t have to pay interest on the balance for that period of time.
Typically, these interest-free periods last from 12 to 24 months.
To sweeten the deal:
Some cards may waive the balance transfer fee, which usually ranges from 3-5% of the balance.
If you can manage to pay off the debt you transfer to the credit card during the interest-free period, you can save a huge amount of money.
If you don’t pay off your full balance by the time the interest-free period expires, you’ll start accruing interest normally. Even a small balance can incur huge interest charges because credit cards can charge 20% in interest or more.
If your priority is reducing your monthly payment, a long-term personal loan is your best bet. If you have a lot of extra money in your budget and want to be debt-free as soon as possible, look for a balance transfer credit card.
Paying down debt and building an emergency fund are both very important steps towards healthy finances.
Choosing which to prioritize can be difficult, but the best answer is to do both.
Make sure you have some money on hand to handle emergencies, then shift some of your focus on paying down your most expensive debt.