Should you build an emergency fund or pay off debt?
With inflation skyrocketing and economic uncertainty on the rise, it's no wonder that American debt levels are climbing.
A recent survey from debt management company Spinwheel, found that 55% of Americans carry credit card debt, 42% have auto loans, 21% have medical debt, 19% have personal loans and 11% have buy now pay later loans. And nearly 1 in 5 Americans have student loans.
While getting into debt can happen quickly—especially with inflation eroding our purchasing power—getting out of debt is often a much tougher journey. One of the most common questions people ask when trying to pay off debt is: Should you build an emergency fund or focus on paying off debt first?
The short answer is that everyone should have some money saved to cover unexpected expenses, but the exact amount and how much you should save while paying off debt depend on your unique situation.
What is an emergency fund?
An emergency fund is a financial safety net designed to cover unexpected expenses or financial hardships. Anyone who has ever tried to stick to a budget knows that life rarely goes according to plan. Unexpected medical bills, home repairs, or even job loss can throw your financial plans into disarray.
Your emergency fund protects you from having to rely on credit cards or taking on more debt when these unforeseen expenses arise. Ideally, most people should aim to have about six months' worth of living expenses saved for emergencies. However, if you're carrying significant high-interest debt, starting with a smaller emergency fund may be more practical.
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When to Prioritize An Emergency Fund Over Paying Off Debt
1. When you don’t have an emergency fund at all
If you have no money set aside for emergencies, your first priority should be to build a basic emergency fund.
When you're struggling with high-interest debt, it might seem logical to throw every extra dollar at your debt to pay it off as quickly as possible. The temptation to use any available funds to reduce debt is strong, especially when the interest rates are eating away at your finances.
However, one of the biggest mistakes I see people make when trying to get out of debt is neglecting an emergency fund. Without it, any unexpected expense can force you to put new charges on your credit card, creating a cycle that makes it nearly impossible to escape debt.
To break this cycle, you need to get ahead of unexpected expenses by saving money in advance. While popular advice from financial guru Dave Ramsey suggests having at least $1,000 in an emergency fund before focusing on debt, we all know that $1,000 doesn't stretch as far as it used to.
A more realistic goal is to have one month's worth of living expenses set aside before paying extra toward your debt.
2. When you have only a mortgage, auto loans, or student loans with lower interest rates
If your debt consists primarily of a mortgage, auto loans, or student loans with low interest rates, these debts are generally less expensive to maintain. They typically don't strain your finances as much as high-interest debt—unless the loan amounts are large and take up a significant portion of your income.
In these cases, it makes sense to focus on building your emergency fund first. Make your regular debt payments but prioritize saving for emergencies. Once you've built up six months' worth of expenses in your emergency fund, you can consider paying extra toward your debt, boosting your retirement savings, or investing in a brokerage account.
When to Prioritize Paying Debt Over an Emergency Fund
1. When you already have one month worth of living expenses in an emergency fund and have high interest debt to pay off
Once you’ve saved one month’s worth of living expenses in your emergency fund, it’s time to shift your focus to paying off high-interest debt. The fastest way to pay off debt is to prioritize those with the highest interest rates. This approach reduces the total amount you’ll pay over time and helps you become debt-free sooner.
However, I understand that some people find it more motivating to pay off smaller debts first or those that cause the most stress or shame. If this approach keeps you on track, it’s okay to use it—but be aware that it will cost you more in the long run.
Regardless of your strategy, make minimum payments on all your debts and allocate any extra money toward the debt you've prioritized. Once you've eliminated one debt, apply the amount you were paying toward the next one on your list.
2. When you don’t have enough to make your minimum payments.
Failing to make your minimum payments can lead to severe consequences: late fees, a drop in your credit score, debt being sent to collections, and even the risk of losing your home or other secured assets.
If you're struggling to meet your minimum payments, it's crucial to get help immediately and prioritize debt payments over building an emergency fund. Reach out to reputable organizations like the National Foundation for Credit Counseling or a local non-profit for assistance.
I’d be happy to help you find a resource that can help—send me an email!
Finding the Right Balance
Balancing debt repayment with saving for emergencies is a delicate dance. While it's essential to pay down debt, having an emergency fund ensures you're not left vulnerable when life throws you a curveball. By carefully evaluating your situation and finding the right balance, you can build a solid financial foundation and work toward a debt-free future.
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