Is it Better to Pay Off Debt or Build an Emergency Fund?

This seems to be one of the age-old questions, doesn’t it? Especially when it comes to tax-return season, this one floods my inbox! “Lauren, is it better to pay off debt or build an emergency fund?”

The easy answer: it depends.

As with most things, everyone’s situation is different. You’ll want to assess your financial health and forecast and make the best decision you can.

Is it better to pay off debt or build an emergency fund?

Once you decide to start tackling your debt and building up your savings, wouldn’t it be nice if there was a clear-cut formula at how to get it done quickly and easily? I’ll do my best to give you a few scenarios, and try to choose the one that fits best for your situation. Sometimes a combination of working to pay off debt AND build an emergency fund at the same time works best.

If you have high-interest cards, focus on paying them off

It seems like most families have carried credit card debt, but during 2020 with people losing their jobs (and let’s be honest, online shopping was lit!), credit card balances are at an all-time high. The average balance on single credit card is over $6,000. Most people have four – that’s $24,000 in JUST credit cards! Add to that your mortgage, car payments, or student loans.  The average interest rate on credit cards is 16.15%; those with poor credit may pay over 25%.

This means you are paying more in the long run with these high-interest cards. It will be worth it to you to consider a debt paydown method to pay off at least some of the cards and lower these payments or research some debt consolidation to reduce the amount of interest before building your emergency fund. 

If your income is uncertain, focus on your emergency fund first

During 2020 we experienced first-hand how fragile many of our jobs were. Many were unprepared for job loss and months of financial uncertainty. Still, others have unpredictable jobs by nature: food and beverage, landscaping, and freelance. Having an uncertain income means you need to be prepared for those leaner months when you aren’t sure how to cover expenses when your income isn’t enough.

Having an emergency fund can lend itself to some peace of mind. Of course, if your job itself is uncertain you may wonder how to build an emergency fund quickly.  If you would rather not DIY this, I have an online course and a supportive community of women doing the same thing, and you can find out more details about the $1000 Savings Course here.

What is a good amount to have in an emergency fund?

Most financial experts recommend $1,000 as the benchmark for how much to have in your emergency fund.  A recent article by CNBC cited that almost half of Americans can handle a $1,000 emergency paying for it with money in savings. The problem becomes, many emergencies such as car repairs and medical bills, can cost an average of $3,500.

So how much should you have set aside for an emergency?  Some experts recommend having three to six months of expenses set aside for emergencies. That can sound like a lot, but you don’t have to do it all at once.  If you use a financial planner, you will have a better understanding of what your monthly expenses are, and also how to budget each month and build your emergency fund adequately.

Will paying off debt instantly improve my credit?

Several factors are used to calculate your credit score, also known as your FICO score. Reporting agencies use your debt to credit ratio, the number of timely payments you’ve made, and your debt to income ratio. Believe it or not the number of credit inquiries into your account, whether or not you’ve had any bankruptcy filings, and whether or not you’ve been arrested also get factored into the equation!

Considering all that goes into your credit score, paying off your debt won’t instantly improve your score. You should be paying off your debt because it improves your financial health. Once you have freedom in your budget you can plan for things you really want and not be tethered to monthly debt payments.  If you want to learn more about the truth about your credit score, I have an article for you here.

Final thoughts about whether to pay off debt or build an emergency fund

Bottom line is both of these should be a priority for you in your budget plan. You’ll want to work to pay off debt and build your emergency fund. It may take some creativity, but you can do it!

• The average emergency expense around $3500. While most Americans can likely handle a $1,000 bill from savings, they aren’t sure how to cover more than that.
• A rule of thumb is having three to six months of expenses set aside in an emergency fund.
• If you have high-interest cards, pay them off first. The money you are paying in interest will outweigh the benefits from your emergency fund.
• You may also consider a debt consolidation loan to help offset your high-interest cards.
• If your income is uncertain, work to build your emergency fund first.
• If possible, work your budget to pay off debt and build savings in tandem. I use a cash envelope system and ensure money is allocated to each area every month.

You may also like:

How Budgeting Can Keep You From Debt

How to Get Your Budget Back on Track with 7 Easy Steps

The 5 Best Ways to Use Your Income Tax Refund

How to Focus Your Finances in a Pandemic Changed World