Should You Build an Emergency Fund or Pay Off Debt?
An emergency fund is a cushion for unexpected expenses, tiding you over during periods of unemployment and helping you avoid high-interest debt in an unexpected situation. But building or maintaining one can be difficult if you’re already repaying debt.
Whether you should prioritize your emergency fund or pay off debt will first depend on your unique financial situation.
|Replenish emergency fund or pay off debt?|
|Save money if …||Pay off debt if …|
|You don’t have an emergency fund||You have an immediate obligation to pay off the debt|
|You only have “good” debt that doesn’t drain your finances||You’re struggling to keep up with high-interest “bad” debt|
|You want to avoid new debt for a future expense||You have a short-term need to improve your credit|
When your emergency fund should be a higher priority than paying off debt
You don’t have an emergency fund
Why should creating an emergency fund be a top priority? Emergency funds help you avoid taking out high-interest debt (such as revolving credit card balances and payday loans) when you need money for an immediate expense. For example, if your car breaks down and requires an expensive repair, it’s best to pay in cash rather than taking out debt that you have to pay interest on.
Emergency funds also help keep you afloat during greater periods of distress. If you suddenly lose employment and aren’t bringing in any income, you’ll have a safety net to help pay necessary monthly expenses, such as rent and utilities. Paying these bills helps you avoid fees, eviction, car repossession and utility disconnection.
You only have ‘good’ debt that doesn’t drain your finances
Debt that you utilize to help finance appreciating assets, such as a mortgage for a home purchase, is considered good debt. Some types of good debt include:
- Mortgage debt
- Student loans
- Short- to medium-length auto loans
- Credit card debt that you pay off every month
While you should always make at least the minimum payment on all debts, it’s more important to start an emergency fund than it is to pay extra toward good debt like your mortgage or student loans.
You want to avoid new debt for a future expense
Planning for a large purchase by budgeting and paying in cash is a good way to avoid unnecessary debt and save money on interest. If possible, you should save money for large expenses, rather than paying extra toward debt first and then taking out debt again.
Of course, this is where discretion is needed. For instance: It may be more productive to pay off high-interest revolving credit card debt rather than to save up for home renovations, which could be financed on good terms using a home equity loan. Consider loan terms, such as APR and loan length, before deciding whether to save money or pay off debt.
When paying off debt should be a higher priority than your emergency fund
You have an immediate obligation to repay the debt
Paying a mortgage, auto loans and other debts that keep a roof over your head should always be your top priority. It may seem obvious, but you should never skip minimum monthly payments on debt in order to grow your emergency funds. Skipping debt payments could result in the following consequences:
- You’ll be charged a late fee
- Your credit score will drop
- The lender may send your debt to collections
- Your property may be seized by the bank (in the case of secured loans)
Consider your loans and other necessary living expenses when building your budget. Money that falls outside of your “needs” can be used for savings or additional debt repayment.
You’re struggling to keep up with high-interest ‘bad’ debt
Paying down high-interest consumer debt should be your first priority if that debt is draining your income and keeping you from saving money. Bad debt siphons money from your monthly budget through interest payments that you’ll never get back. A revolving credit card balance, payday loan debt and high-interest personal loan debt can all hold you back from reaching your financial goals.
By tackling bad debt with a more aggressive payoff schedule, you’re saving yourself money on interest payments and getting rid of debt faster so you can start your emergency fund as soon as possible. When you make more than the minimum payment on your credit cards, for example, you’ll save money and pay down your debt faster:
|The cost of paying the minimum on credit card debt|
|Payoff strategy||Minimum monthly payment||Aggressive debt repayment|
|Time to pay off||60 months||19 months|
|Total amount paid||$12,627||$9,382|
The table above shows how consumers can save thousands and pay down credit card debt in a fraction of the time by allocating more income toward debt repayment. If bad debt is keeping you from building your savings, you might also consider refinancing high-interest debt with a debt consolidation loan or a balance transfer credit card.
You have a short-term need to improve your credit
Many life events and milestones require you to borrow money. If you plan on purchasing a home, buying a car or pursuing higher education, you’ll more than likely have to take out a loan. Consumers with higher credit scores are more likely to receive loan offers with better terms, such as a lower APR. If your credit score is on the lower side, you should consider improving it before you take out a loan.
One way to quickly improve your credit score is to pay down debt for a more favorable debt-to-income ratio. So if you plan on borrowing money in the near future, whether it’s for a debt consolidation loan or a mortgage, paying down debt to increase your credit score may be a higher priority than building your savings.
When you might (or might not) use your emergency fund to pay off debt
If your emergency fund has so far gone unused and is continuously growing with accruing and capitalizing interest, you might think it’s needlessly overflowing. In this case, do the math to determine if you have more than you need for three to six months of expenses (see emergency fund size, below). Yes, it could be wise to apply any extra change in your emergency fund toward your debt obligations, particularly for higher-interest accounts.
Consider, however, the possibility of investing your extra emergency funds. If you could earn more interest through investing (say 7.00% with your financial advisor’s help on a brokerage) than the interest you would have to pay out on “good” debt (perhaps a student loan tagged at 4.50%), it might be smarter to prioritize investing over debt payoff.
If your fund is merely funded or not fully funded, on the other hand, borrowing from it to pay down debt is a thornier question. Yes, it could help you in the short-term, particularly if an emergency loan payment would stave off a serious consequence like delinquency. But doing so would put you at risk of not being able to cover a sudden, unforeseen event like a job loss or hospital trip. Whether you’re willing to bear that risk — and have a plan for the potential fallout — is up to you.
The bottom line: Using emergency funds to pay off debt isn’t a sustainable strategy. If you’re looking to your socked-away savings to get you out of debt, look for longer-term solutions that will keep your monthly dues more manageable. You might consider debt consolidation as a means to having a lower payment amount, for example.
How to start building your emergency fund
Create a budget
The first step to building an emergency fund is budgeting your money. Creating a budget allows you to analyze your past spending and plan for future expenses. Once you have a better idea of your income and spending habits, you can decide how much room you have in your budget to allocate toward your emergency fund.
How much of your income should you save every month? About 20% of your income should go toward savings, while 50% should go toward “needs” and 30% should go toward “wants,” according to the 50/30/20 budgeting rule. However, it might make sense to save more or less depending on your circumstances — a senior who wishes to retire soon may contribute more toward savings, while a fresh college graduate may not have as much income to allocate to savings.
Set a goal for your emergency fund size
An emergency fund should cover three to six months’ worth of expenses. Start with a small, achievable goal, and work your way up. Maybe your initial goal is to get your emergency fund to $1,000, or maybe it’s to save one month’s worth of living expenses. Once you’ve reached this realistic milestone, keep going until you’ve built savings that can keep you afloat without the need for emergency loans.
This is another step where budgeting comes in handy, since creating one forces you to tally up your monthly expenses. For example, if you want your emergency fund to be three months’ worth of expenses, and your monthly expenses are $2,500, then you’d want your emergency fund to have $7,500.
Where to keep your emergency fund
A high-yield savings account is the best option for storing your emergency fund. That’s because it allows you to grow your savings and withdraw cash from your account without fees, which means you can have quick access to your money if you need it in an emergency.
When choosing a high-yield savings account, look for one with a high APY (annual percentage yield). This is an indicator of how much money your account will earn in interest in one year. Read the account terms to get a better understanding of how often you can withdraw funds.
How to pay down debt fast with debt consolidation
If you’re wondering whether to build an emergency fund or pay off debt, you might consider debt consolidation, which merges all your debts into one fixed monthly payment with a lower APR.
Consolidating debt can potentially help you pay down debt faster, lower your monthly payments and save money on interest. When you save money on your monthly debt repayment, you can allocate more money toward building an emergency fund.
Compare your debt consolidation options below:
|3 common ways to consolidate debt|
|Debt consolidation loan||Balance transfer credit card||Home equity loan|
|What is it?||A lump-sum personal loan that lets you pay off virtually any type of debt over a set period of time||A credit card that allows you to transfer the balance of multiple higher-interest credit cards into one place||A loan that lets you tap your home’s equity to pay off higher-interest debts|
|Who is it best for?||A good-credit borrower who can qualify for a low APR and has multiple types of debt.||A good-credit borrower who can qualify for a 0% APR offer and who only has credit card debt.||A homeowner who has equity in their home and is willing to put their home up as collateral in exchange for lower APRs.|