Between high inflation and rising economic uncertainty, it should come as no surprise that the amount of debt Americans carry has been on the rise.
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 is easy (especially with inflation eroding our ability to buy necessities), getting out of it is not. And one of the most frequently asked questions from people who are trying to pay off debt is whether it is best to build an emergency fund or pay debt first.
The short answer is that you should always have some money saved to cover unexpected expenses, but how much it should be and how much you should contribute while paying off debt depends on your situation.
What is an emergency fund?
An emergency fund is simply money that you set aside to cover unexpected expenses or financial hardships. Anyone who has tried to create a budget knows that things never go according to plan. You forget that you had to pay for something, something in your house breaks, or you had an unexpected medical expense. Or worse, you get laid off or lose your ability to earn income.
Your emergency fund is what protects you from having to rely on credit cards or debt when these things happen.
Learn More:
Emergency Fund Basics
How to Build an Emergency Fund When You Have No Money
Ultimately, most people should have about 6 months of expenses saved for emergencies. However, those with significant, high-interest debt, may be better served with a smaller initial amount.
When to Prioritize An Emergency Fund Over Paying Off Debt
1. When you don’t have an emergency fund at all
Anyone who doesn’t have any money in savings needs to prioritize building an emergency fund.
When you’re struggling with crushing, high-interest debt, it makes sense that you would want to prioritize paying it off. After all, you want to get out of debt as fast as possible. It can be mentally and emotionally difficult to see that money sitting there when you could be using it to pay off debt faster.
But this is one of the biggest mistakes I see people make when it comes to getting out of debt.
What usually happens is that you put every available dollar toward debt, and then something happens that you didn’t plan for, you don’t have the money to pay for it, and you put that new charge on your credit card. This makes it nearly impossible to get out of debt.
In order to break this cycle, you must get ahead of all of the unexpected expenses by saving money in advance.
According to popular personal finance advice from Dave Ramsey, you should have at least $1000 in an emergency fund before focusing all of your resources on paying off debt. While this may have worked at one time, we all know that $1000 doesn’t go very far.
To better protect yourself, aim to have an amount equivalent to one month of living expenses set aside before paying extra toward debt.
2. When you have only a mortgage, auto loans, or student loans with lower interest rates
Mortgages, auto loans, and student loans with lower interest rates aren’t as expensive to maintain and typically aren’t as much of a drain on your finances (the exception being loans in high amounts that take up a high percentage of your income).
With these types of debt, you will make your regular payments and then prioritize building an emergency fund over paying extra on this debt.
Once you have 6 months worth of expenses in your emergency fund, then it may make sense to pay extra on your debt, save more for retirement, or invest in a brokerage account. Work with a fee-only financial advisor to find out which option is right for you.
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 have a basic amount in your emergency fund, you should switch to prioritizing paying off debt. The fastest way to pay off debt from a numerical perspective is to prioritize debts with the highest interest rates. This means that you’ll be able to pay off your debt faster overall, using less money.
However, many people prefer to prioritize debts that have the smallest balance or that cause them the most pain or shame. It’s okay to do this if you need to in order to motivate yourself, but know that this is ultimately a more expensive way to pay off debt.
Either way, make the minimum payments on all of your debts and put any extra money toward whichever debt you’ve prioritized. Once you’ve paid off that debt, transfer the amount you had been paying to the next debt.
2. When you don’t have enough to make your minimum payments.
If you don’t make your minimum payments, you’ll be subject to late fees, your credit score will drop and your debt could be sent to collections. If you have a secured loan, like a mortgage, you could be at risk of losing your home or other property.
These negative consequences are severe. If you can’t make your minimum payments, you need to get help immediately and prioritize debt payments over an emergency fund.
To get help, contact a reputable organization such as the National Foundation for Credit Counseling or a non-profit near you.
