Great Debates: Debt Repayment vs. Emergency Funds

Here’s another persistent and oft-debated question: when you manage to control your expenses and actually have money left over at the end of the month, what do you do with it?  Do you pay down any debt that you happen to hold, or do you put the money away into an emergency fund?  As with most serious debates, both sides raise some good and interesting points.

For many people, paying down debt makes the most financial sense.  If you have credit card debt with an interest rate of 25% (sadly, a standard rate for many card issuers), then for every one hundred dollars you put towards paying down the debt will save you twenty-five dollars a year.  Even if you were able to find a completely safe account that yields 5% a year (which isn’t too likely, given the current state of most savings account yields), you’d still be losing twenty dollars per year for every hundred dollars you keep in your emergency fund.  There’s also the psychological factor to consider.  Being able to look in the mirror and say, ‘Yes, I’m debt free’, or at least, ‘I’m free of high interest credit card debt’ is a wonderful feeling.

As always with these great debates, the other side makes a strong case, as well.  Having an emergency fund has its own psychological benefits: if you find yourself facing a large, sudden expense (in other words, an emergency), being able to pay for it out-of-pocket without adding onto your debt.  Furthermore, there are some emergencies where you are unable to use credit cards, and having the necessary funds available for such cases will be a huge morale salve.  (For example, my fiance has a little dog named Toby, and his vet doesn’t accept credit cards.  If we don’t have cash on hand to pay for Toby’s treatment, Toby will end up suffering.)

So, what’s someone who faces both a sizable amount of debt and no emergency fund supposed to do?  The best option is to split the difference; work to build an emergency fund and pay down your debt at the same time.  A short list of actions to take:

1) Build up a small emergency fund.  Not a full emergency fund, which would cover six to twelve months of expenses, but enough that you can cover the more common ’emergencies’ that arise in life; things like car maintenance, doctor’s trips, or fixing a leaky toilet.  We’re not trying to prepare for a financial disaster at this point, but simply to smooth out our monthly spending.  One month worth of expenses, put into a high yielding, online savings account (SmartyPig would be ideal for an emergency fund) should suffice in most cases; but if you have reason to believe you could end up needing more in the near future (if there’s someone in your household with health issues, for example), then by all means, build a larger emergency fund.

2) Start paying down the highest interest debt.  Ideally, you should make the minimum payments to all your debts, and devote any extra money (now that you’ve got a small emergency fund cushion) to the debt with the highest interest rate.  Once you have paid off that debt, you can put all that money into paying off the next highest interest rate debt, and the process will continue from there.

3) Increase the size of your emergency fund.  Once you have the highest interest rate debt out of the way (any debt with an annual interest rate of more than 8%, let’s say), you should start increasing your emergency fund with some of the money you are paying each month.  The last thing you want is to add more high interest debt now that you have eliminated your previous debt.  You can start splitting the money you had been putting into debt repayment between paying off the rest of your debts and building up your emergency fund.  How much you put towards each goal will depend on how comfortable you feel with your emergency fund and how much you want to be completely debt free.

4) Decide on your next course of action.  By this point, you have paid down your highest interest debt, are only paying low interest rates on your other debt (if you have any debt remaining at all, that is), and have built up a sizable emergency fund.  Where you go from here depends on your goals and current situation.  You could start investing for the future, agressively pay down the rest of your debt, or start saving for a specific purchase.  Each choice is equally valid, and any one of them could be a good option for you, depending on your goals and other factors.

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