Pay off debt or create an emergency fund first?
One question I see A LOT on the interwebs is whether you should pay off debt or create your emergency fund first.
And not surprisingly, there are A LOT of different opinions on the matter.
Here’s my thought:
There are two perspectives when it comes to answering this question.
Should you pay off debt or create an emergency fund first?
The technically “financially correct” answer is that if your debt carries an interest rate that’s higher than what you can earn on your money (if you invested it), then you should pay off your debt first. Otherwise, you may be making money on your savings but it’s not enough to cover the interest you’re paying on your debt.
That said… the other perspective is grounded a bit more in reality and motivational strategy. If you’re not saving until you pay off all of your debt, you may constantly feel stressed that you don’t have any backup and frustrated that it feels like all your money is going to debt.
That’s why I personally prefer a blend of the two –
✅ Create a debt paydown plan that gets your debt paid off within the timeframe you want (maybe 1-3 years, depending on how much you have)
✅ Decide what percentage of your income you want to set aside in an emergency savings fund, and how much you want to put into investments. While you may not be able to hit these amounts right away (or even until you pay off your debt), you can start by working towards them.
So let’s say you earn $5,000/month after taxes. After expenses, you have $800 left over. You have $12,000 in credit card debt at an average 18% interest rate, and you’d like to have it paid off in 2 years, if possible. Your goal is to have 3 months of expenses in your emergency fund ($12,600).
In order to hit your debt repayment goal, you’ll have to pay $599/month for 24 months. This leaves you with $201/month left over to put towards your emergency savings.
Depending on your personal motivational style and preferences, you have a few options:
1️⃣ Pay $599/month towards your debt for 24 months. Put the remaining $201/month into your emergency savings. Once your debt has been paid off, you can put $800/month into your emergency savings. By the end of the 24 months, assuming an average 1% interest rate, you’ll have $4,870 in your emergency fund and it will take you approx. 10 more months to hit your emergency fund goal.
2️⃣ Pay $800/month towards your debt. At this rate, it will take you 18 months to pay off your debt (6 months early!). Then, you can start putting $800/month into your emergency fund. This will save you approx. $625 in interest and will give you 6 more months of earning potential in your emergency fund. Under this option, it will take you approx. 16 months to hit your emergency fund goal once your debt is paid off.
The finance gurus would say to pay off your debt first, because that 18% interest rate is eating away at any earnings you make in your emergency fund or investment account. And there’s nothing wrong with this – this is sound logic.
But it can also feel good to have something, especially when you’re feeling bogged down by debt. If that feels like you, saving – even just a little – may give you the boost you need to tackle that pesky debt once and for all.
For more on this topic, you can listen to our podcast episode all about the lessons we can learn from big businesses.