Episode 117: Should I Pay off Debt or Build an Emergency Fund?

When funds are tight, it is hard to know whether to pay down your debts or build your savings. Dawn discusses the pros and cons of each to help you decide where to focus your efforts first.

Show transcript:

Welcome to the SimpleMoney Podcast, where we make personal finance less intimidating. I’m Dawn Starks, a financial planner and lover of the simple life. I’m here to talk about money and simplicity. Let’s dive in. This is Episode 117: Should I Pay off My Debt or Build an Emergency fund? When people are trying to improve their financial lives, sometimes they come up with this question. Should I focus on paying off my debt first? Or should I focus on building my cash cushion, or my emergency fund first? And so,

of course, the answer is that you really need to do both of those things. They’re both really, really important. But sometimes you have to make choices between one and the other because you just don’t have adequate funds to work on both those goals at once. So if you have to choose one path or another, let’s talk about when you would choose paying off debt first and when you would choose working on your emergency fund first. So let’s start with focusing on paying down your debt first. So here are the conditions,

or maybe the situation, that you would consider paying down your debt first. So you would do that if you were barely making ends meet. So if you’re barely making ends meet, it’s hard to get money saved because you’re going to keep needing it. And chances are you’re probably relying on debt, so it’s better to focus on getting your debts paid down. So any extra money that you have, if you’re barely making ends meet, you should focus on paying down your debts, so that you can eliminate a payment for one, but for two, avoid accumulating more debt.

Another scenario where you would want to focus on paying down debt first is if you’re living paycheck to paycheck and you’re only making minimum payments on your credit cards. So this is similar to the first scenario. But this is a situation where you’re only making the minimums, and I encourage you to really focus your efforts on paying more than the minimum. Have you ever taken a look at your credit card bill, where now, with the new laws that passed – I don’t know it’s been quite a number of years now –

they are required to state on the front of your statement how long it will take you to pay off that balance that you have, given the minimum payment that’s required?

And so, oftentimes you’d be shocked to see that it might be 18 or 20 years that it would take you to pay it off.

And they also report how much total you will have paid in interest if you do that, if you pay off the debt that you have just making the minimum payments.

So it’s super important to focus on making more than the minimum payments. And if you say “That’s impossible,”

just focus on getting $5 more than the minimum, and then you can increase it to $10. And I just encourage you to do whatever you can to get those payments higher than the minimum so that you can accelerate paying down those debts.

Likewise, if you have multiple credit cards, focus on the one that costs the most, the one that has the highest interest rate.

That’s the one that you should try to focus on, adding the extra principal payments to it so you can pay it down.

So I say that in those scenarios you should focus on paying down your debt first rather than building your savings,

because you’re really looking for stabilization. So, stability. You’re looking for trying to stabilize your situation and get yourself kind of on an even keel.

And when you carry a bunch of debt, it’s a challenge for that, that cash-flow you have every month.

And so what we’re trying to do is get ahead of it a little bit by paying things down.

But you know also, debt is a is a measure of your financial worthiness. So the more debt that you have,

the more difficulty you’ll have being able to acquire other debt, you know, to try to refinance the debt you have,

or if you needed to get a car or wanted to buy a home, having a lot of debt is a challenge.

So what I mean by that is, your credit score is super important these days, and that’s a topic for another day as to why, and whether that should actually be so important.

But that’s the world we live in here in the United States, is that the credit score is king,

and it now is for more than just getting credit. So your credit score doesn’t just matter for being able to get a good rate, interest rate, on any new credit you want to take out.

It’s also important for getting good rates on your insurance for your car, and sometimes getting a job. So oftentimes,

employers now are pulling your credit score to see whether or not you’re good with your money. Or maybe you’re in a bad situation with your money,

so they want to know that. So your credit score is very important. Whether or not it should be or not is a totally different story,

but so you should focus on getting those debts down and keeping them under control. Once those debts are under control,

then you can focus on getting an emergency fund going and getting that built up, and then also tackling the rest of your debts.

But you really just want to kind of get your debts under control, where you’re starting to accelerate those payments and get them paid off.

I’m not suggesting you have to wait till all of your credit card debt is paid off before building an emergency fund.

I just want you to reach a point where you are, where you have good momentum towards paying them off and that you’ve sort of gone beyond that ‘stability’ level.

So now let’s turn our attention to when should you focus on building an emergency fund first. I would suggest you build an emergency fund first if you’re making your minimum debt payments easily every month,

and you have the ability to pay more than the than the minimum. Then, like I was just saying,

then you can turn your attention to starting to build your emergency fund too. I still wouldn’t suggest that you completely shift your focus off the debt-pay off and on to emergency funds, but that’s when you can consider maybe doing a little bit of both.

Once you’re doing the minimum payments easily and you’re able to put some extra on the minimums. Another time it would be good to focus on building an emergency fund

first is if you tend to lean on debt when you have an unexpected expense. So if your pattern is that you’re going along and everything’s hunky-dory, and you’re just making all your bills just fine,

everything’s getting paid on time, and then something unexpected comes up and you have to turn to credit because you don’t have enough income to cover that unexpected expense.

That would certainly be a signal that you could use an emergency fund, because it sounds like your general situation is stable,

but what you really need is a cushion for those unexpected expenses. And, of course, then when that unexpected expense comes up and you use your emergency fund for it,

then you need to build it back up, so you need to be able to replenish it and build your savings again.

So those are a couple scenarios where I would focus on building your emergency fund before you get really serious about paying off your debts.

So remember, again kind of the threshold for me is stability in being able to make all of your obligations every month and being able to pay some extra on your debts. Because you don’t want to be just making minimum payments,

or you will be making them for a very, very long time, and it will end up costing you a lot.

So when you are starting to work on both of these things together, you do want to make sure you’re getting extra paid on those credit cards,

as well as starting to increase a little bit what you’re saving. So your goal should be to get started on both of those things,

paying off your debts – and by paying off your debts, I’m referring to consumer debt, like credit card debt and your car payment,

perhaps, maybe even student loans. I’m not referring to your mortgage at this juncture. I’m just talking about the really expensive debt that people tend to carry.

And so once you’re working on both of those things, and your goal should be to start increasing the amounts, so that you’re heading towards both those goals.

So, for example, if you’ve started making your minimum payments and now you’re making $20 extra on your minimum payment every month,

try to aim for $50 extra every month. And then if you’ve got your savings going and you’re putting $50 a month in your savings,

try to increase that to $60 a month. So what you want to be doing is, as soon as it gets comfortable,

start ratcheting up, you know, what you’re doing, more to the debt, more to the savings. By moving it up slightly every month, or even within a month,

then you’re going to not miss those amounts in your budget because it’s so incremental. But you have no idea how important those little incremental increases to your debt-payoff efforts and your savings efforts will be.

And at first it will not seem like you’re making very much progress, but it will, over time,

grow. So, for example, let’s say you’ve got your savings target, and you’ve got a target of $100.

So then once you get to your $100 savings, then you can increase that to $200, and to $500. That’s your overall goal.

But you get there by making those incremental changes by increasing it just a little bit every month and then sort of snowballing it up into your emergency fund.

Or, in the case of the debt-payoff, you’re paying just a little bit more each month on the minimum payment.

And that way you’re going to snowball that debt balance down by increasing the amount. So you’re snowballing the amount that you’re applying to that debt.

So your ultimate goal for your emergency fund should be maybe $5000, or an amount that’s equal to three months of your monthly household expenses,

whichever is greater. So if you tally up and you say, in order to cover all of my monthly expenses for the household,

I need $6000 then – I’m sorry that you need $3000, then you want to multiply that by three,

so then $9000 would be your goal. So if $9000 seems like an outrageously huge amount of money, then just shoot for $5000, and then you can increase it again doing that incremental increasing.

So if you’ve listened before, you know that I’m a fan of automation. So you know that I say set it up automatically so that the money just gets plucked right out of your checking account and goes to savings. Or you can set up your credit card payments to go automatically and add that extra principle.

You can do those things, but automating doesn’t mean you forget about it, okay? Because if you want to do this incremental improvement of your savings and your debt-payoff,

you’re going to have to pay attention to it. And you’re going to have to change the automation when it’s getting comfortable. And again, that may be every couple of weeks, it may be every month, it may be every few months,

whatever it takes for you. So think about those things and think about where you are, and what brings you the most stress. Because you want to focus on the area that’s bringing you the most stress.

So it’s really difficult for somebody like me to say everybody should focus on this first or everybody should focus on that first,

because everyone’s different. So you have to decide what causes you stress in your life, and then think about that, and then focus on the debt-payoff or the savings-building,

whichever one is going to be the thing that will relieve your stress faster. Don’t fall prey to financial advisors who say,

“Oh, you’ve got no business saving until you get your debts paid off,” or you know “You need to have an emergency fund first,

no matter what kind of debt you have, you have to build your emergency fund.” I think that’s flawed advice because everyone’s situation is slightly different,

and it’s impossible to say that everyone should do one thing or another. So you have to look at your situation and just figure out your stress points, and then decide which one of those two goals you’re going to elevate to first place,

work on that one as hard as you can until you’ve got it going, then you can add the second one in. Because ideally,

if you have a consumer debt and need to build your emergency savings, you’ll be doing both of those things at the same time.

So you’re going to be aiming for that. Okay, so that’s it for today. So I hope you’ll tune in again next week for another episode of

the SimpleMoney Podcast. Thanks for listening. If you enjoy the SimpleMoney Podcast, be sure to subscribe on your favorite podcast player.

We’d love it if you would leave us feedback and a review. And don’t forget to check out my blog at simplemoneypro.com.

There you’ll find dozens of posts about financial issues that matter to you, as well as thought-provoking pieces about simplifying your life.

Bye for now.


2 responses to “Episode 117: Should I Pay off Debt or Build an Emergency Fund?

  1. I have 8,500 in debt and my husband has a student loan of 36,000. We have 9000+ in savings outside of retirement accouts. We are retired. My husband would like to pay off the cc debt (it is interesting free at this time),but I want to wait until after we figure our taxes. I am sure we will owe. We also need a decent bed and we can get one for a very good price in March. So is it better to use our saving to pay debt or for upcoming expenses?

    1. Hi Judy! If your credit card debt is currently at zero interest, I’d wait to see how the taxes come out and get the bed you need with your savings. Depending on how much is then left, you can decide to leave it in savings and find other ways to pay down your debts OR use some savings to pay down debt. There is no perfect answer, unfortunately. ūüôā Good luck!

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