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This is a question that comes up frequently. So, don't feel like you are alone. Emergency fund or pay off debt?
Should I save up an emergency fund? Or should I pay off debt? What is more important to reach financial freedom? What should I choose?
Here is the bottom line.
Most people unfortunately don't do either – save money or pay off debt. Why? They get paralyzed in trying to make the decision of which comes first. Plus the financial advice is SO vast and different that the average person would rather be doing anything else than looking at their financial picture. So, right now, we are going to simplify this for you.
The key point to remember is do you want to manage your money or continue letting your money manage you. Break or continue the paycheck to paycheck lifestyle? The choice is ultimately yours.
So, getting back to emergency funds or paying off debt, which one should come first?
What is the Purpose of an Emergency Fund?
The emergency fund is there to cover real, true emergencies. Back in my college days, I thought that emergency funds was the savings account attached to my checking account to cover an overdrafts. Simple protection thanks to my bank. Um, hello? That young college student was totally wrong.
In a perfect world, an emergency fund would never be touched. It is there in cash you need it.
However, let's jump back to reality. When are in the beginning Money Bliss Steps to Financial Freedom, you will find yourself in more emergency situations. That is completely okay, I promise! You are spending your money differently and it will take time to adjust to saving up for purchases rather than going into debt.
For instance, the car needs maintenance and repairs. Ugh. Those are dreaded words and a pretty price tag to fix it. Until you have sinking funds for car repairs, this would be paid from the emergency fund. And the BIG WIN for you…no need to charge it on the credit card!
The Need to Pay Off Debt
Seriously, debt is the cash flow killer. You are unable to move forward because of the interest payments that never seem to end. The need and desire to pay off debt is real. But, first, think about what got you into to debt in the first place.
Many times the debt wheel starts moving when there wasn't cash available to pay in advance for something. So, in order to stop the debt cycle, you must start saving money in advance.
Why yes, the need to pay off debt quickly is real. But, first you need to stop the debt cycle and the slippery slope of going into more debt.
Emergency Fund or Pay Off Debt?
In order to build a strong financial foundation, emergency fund comes first.
While paying off debt sounds more appealing, an emergency fund will guarantee success.
Forty-four percent of Americans couldn't cover a $400 emergency expense according to a study by the Federal Reserve in 2017. That percentage has actually been approving over the last 4 years, too. Plus, across income levels, that same statistic hardly varied. The lack of an emergency fund causes undue stress and accumulating credit card debt.
All in all, the question of the emergency fund or pay off debt is much like the cart before the horse analogy. How far can you get if you put the cart first?
How Much Cash to Keep for Emergency Fund
At Money Bliss, our recommendation is 2% of annual salary with a minimum of $1,000. Another common question is where to put emergency fund. It is best to keep an emergency fund in an online savings account. The money is set aside and harder to access. But, still within a quick reach.
That brings us to the next elphanet in the room. Should I use all of my cash saved up to pay off debt? If you have more than the recommended emergency fund size, then yes take that cash and pay off debt. Grasp! I know this is difficult for many people to fathom. But, I can tell you from personal experience that in order to move forward, the longer you delay in paying off debt, then you are just delaying the inevitable. It will take much longer it takes get out of your current cycle and to move through the Money Bliss Steps.
For those of you screaming, but I need a bigger comfort than just $1,000, then decide on what works for you and your family. An emergency fund does not include 3-6 months expense or saving for big purchases (that happens during Money Bliss Step #5). It is a simple emergency fund. Who knows what it will cover?? The true emergency fund definition. The absolute maximum recommended emergency fund is $5,000.
What About the Debt Interest Rates
Remember, it is about building a strong foundation. Something that won't blow away in the first emergency.
Put blinders on the debt interest rates for now. Stop using any debt. Then, you can avoid paying extra interest.
Make a plan to get out of your debt once the emergency fund is fully funded.
- Open an emergency savings account. Right now, CIT Bank's Money Market account is offering 1.75% APY, which is over 15 times the national average, with a minimum opening deposit of $100. The higher the APY, the faster you'll save.
- Start saving for that emergency fund. Check out the Money Bliss Guide #2 – Emergency Funds to guide you to a quick path of savings!
- Make a plan to pay off debt. Stop the cash flow killer and start enjoying life. Need motivation? Check out the Guide to Pay Off Debt. Also, get your debt free date here.
You can move past this debate of emergency fund or pay off debt. Don't delay. Start now.