Pay Down Debt or Save Up for an Emergency Fund?

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.

An example

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

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.

The caveat:

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.

Conclusion

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.

When to Use Your Emergency Fund

You understand the importance of an emergency fund and have done a great job in setting one up.

Financial security has been achieved.

It’s important to make sure you don’t spend your emergency fund on the wrong thing, reserving it for true emergencies.

Learn how to identify the correct situation when it makes sense to use an emergency fund (and when it doesn’t).

How Not to Use an Emergency Fund

Here are a few examples of things you shouldn’t use your emergency fund on.

Frivolous Spending

Spending money can be fun. Fancy meals out, a new outfit, or a shiny electronic gadget can all be very tempting.

This temptation can get even worse if you have friends who invite you out for a meal or who are constantly upgrading their own gadgets, making you feel like you’re getting left out.

If you have a lot of money in your emergency fund, it might not seem like a big deal to spend a bit of it on something fun. This is a dangerous precedent to set. One small splurge can quickly become two small splurges, and then three. Soon enough, you’ll find yourself with no emergency fund at all. If a real emergency comes around, you won’t have any way to cover the expense.

This is why setting a budget based on your income is so important. By budgeting for spending on fun, you can stay within your means while having guilt-free money that you can use on whatever you’d like.

Fear of Missing Out on Sales, Deals, or Discounts

Companies, whether they be clothing stores or car dealerships, constantly advertise deals, sales, and discounts on their products. No matter how great a deal seems, it’s not worth spending your emergency fund because you’re afraid of missing out. More likely than not, the product you want will go on sale soon enough.

If something is on sale for an event like Black Friday, you should think about that before the day of the sale comes. Set aside money specifically for use on the day of the sale, that way you have extra cash to go shopping and take advantage of the discounts.

Paying for Home Improvement That Can Wait

Owning a home is like having a constant DIY project to work on. If you have a lot of cash in the bank, it can be tempting to start a new home improvement project, whether it be making an addition, repainting a room, or buying new appliances.

You shouldn’t use your emergency fund for this purpose for a few reasons.

Most obviously, because home improvements, short of repairing catastrophic issues, isn’t an emergency. Emergency funds are for emergencies, not unneeded spending.

Second, even the best-laid home improvement plans can go awry and a small project can quickly become a big one. You don’t want to commit a small part of your emergency fund to a project only to find you need to spend all of your savings to finish it.

A New Car if Your Current One is Fine

Having a car is essential for most Americans. Public transit in all but the largest cities leaves much to be desired and even then it can be inconsistent. You need some way to get to and from work and to be able to travel around.

Cars can also be a fun hobby for many people. It’s not unusual to dream of owning a luxury car or to want to upgrade from your current model. Still, if your current car runs fine, you shouldn’t spend your emergency fund on a new one. Not only will you lack savings to handle true emergencies, you’ll also lock yourself into a new, and possibly expensive, car payment.

When it Makes Sense

Here are some reasons you might use your emergency fund.

You Need a Livable Shelter

One of your first priorities should be having a place to live. If you find yourself without livable shelter for whatever reason, tapping your emergency fund to find somewhere to stay is a good idea. If your roof starts leaking or your utilities are going to be shut off, you should use your emergency fund to rectify the situation.

Utilities like cable, internet, or subscriptions like Netflix are not essential, so you shouldn’t use your emergency fund to cover those bills. Focus on what you truly need: a good roof, electricity, and heat.

You Need to Get to Work

If you don’t have a way to get make money, you won’t have a way to pay your bills or rebuild your emergency fund after you deplete it. If your car breaks down, using your emergency fund to pay for the repair makes perfect sense. If you lose your job because you didn’t fix the car, your emergency fund wouldn’t last long, so using it to ensure you keep your job is a good idea.

You Need to Find a Job

Relatedly, if you need to spend money so you can find a job, do so. This can mean covering your living expenses, which you should reduce to the bare minimum, or it can mean buying an adequate outfit to interview in.

It might also mean purchasing transportation to get to and from interviews or to get the necessary education to find a job. Don’t spend too much on things that aren’t truly necessary. A coding boot camp, for example, isn’t guaranteed to get you a job. But, for example, if you don’t own any formal clothes, buying a shirt and tie to use for interviews would be a good investment.

You Need to Stay Healthy

The most important thing you have is your health. If you’re unhealthy, your quality of life will decrease dramatically. Of course, your ability to earn money to sustain your lifestyle will also decrease if you are unhealthy.

If you get sick, have an accident, or some other health issue comes up, spend your emergency fund on the required treatment. Visit the doctor, get the recommended tests, and do whatever you can to get healthy again. You can worry about rebuilding your emergency fund when you’re better.

The Size of Your Emergency Fund

Once you’ve decided to build an emergency fund, you have to decide how large an emergency fund you need.

A good rule of thumb is to start by saving up $1,000. This is a relatively small amount, but it is enough to handle most minor issues that pop up, like a car repair or unexpected bill.

Once you’ve built your initial emergency fund, focus on paying off high-interest debt. Depending on your risk tolerance and willingness to pay interest, paying off any debt that charges more than 4-6% interest should be your target. You can continue paying the minimum on your lower interest debt.

After you’ve eliminated your high-interest debt, go back to building an emergency fund. Depending on a variety of factors: how many dependents you have, your level of job security, and how hard it would be to find a new job, aim to have 3-6 months’ expenses in your emergency fund. So, if you spend $2,000 a month, aim to have $6,000-$12,000 on hand at all times. This amount will help you weather the storm if you wind up losing your job and have to find a new one.

Where to Keep Your Emergency Fund

There are a few options to choose from when deciding where to keep your emergency fund.

Online Savings Account

The simplest option is to keep your money in an online savings accounts. These accounts rarely charge fees and pay great interest rates. This means that your money will grow over time and helps fight against the effects of inflation.

Online savings accounts sometimes make it difficult to make withdrawals, but if you choose the right bank, you can make electronic transfers without much trouble.

Money Market Account

Money market accounts combine the benefits of savings accounts and checking accounts. They pay a good rate of interest and give you the ability to write checks against the account. That makes it easy to access the money when you need it. As a bonus, many banks offer debit cards with their money market accounts.

The greatest downside of money market accounts is that they tend to have high minimum deposit requirements.

Money Market Funds

Not to be confused with money market accounts, money market funds are offered by investment brokerages as a way to store extra cash. These accounts are not insured by the FDIC, but they can pay a great interest rate. Some brokerages offer rates higher than online savings accounts.

Moving money out of a money market fund is easy. Some brokerages even let you write checks against the account.

Conclusion

Building an emergency fund is an important step in everyone’s financial life. Once you’ve taken that step, make sure that you don’t spend the money frivolously, saving it for true emergencies.