Originally published February 17, 2016
There’s one step in paying off debt that seems so obvious to me that I’ve never really considered an alternative. However, as I read more widely in personal finance, I discovered that many people intentionally skip this important step.
The question is whether to start paying off debt immediately or to first save up an “emergency fund.”
The pure mathematics argument is that every dollar you pay off now, is a dollar you’ll never pay interest on again. Why would you save up a bunch of money that’s earning next to nothing when you could be making progress on both principal and interest by putting all of that toward debt?
You know I love the numbers, but for me personal finance is as much about psychology as math. While you may have to pay a little more in interest and have your debt last a little longer, there are lots of reasons having an emergency fund makes more practical sense than jumping straight into debt payoff mode with no savings at all.
Why you should start debt payoff with an emergency fund
Keep your momentum up
Tackling debt is not for the faint of heart. It takes serious determination to stick with your goal and not give up. Having an emergency fund allows you to handle financial emergencies that arise without derailing your entire debt payoff plan. Being able to cover emergencies (and by that I mean real emergencies, not just splurges) means that you won’t have to incur more debt, but instead can make steady progress toward your goal.
Have peace of mind
This one is huge for me! Knowing that we have a cushion of money available if we need it gave me a sense of security, even amidst serious debt. I wasn’t afraid to throw every extra cent at our debt each month because I could rely on the emergency fund if a crisis were to arise. I can’t image what my stress and anxiety levels would have been without having an emergency fund in place. In reality, we’ve only had to actually use our emergency fund a few times, but having it available really brings peace of mind.
Problem solve creatively
I don’t know about you, but our emergency fund almost feels sacred– like we will do whatever we can to avoid touching it. If you’re like us, you’ll think of more ways to solve your financial crisis when using your precious emergency fund is the alternative. When you have an emergency fund as your backup plan rather than a credit card, you are more likely to come up with other solutions or decide the situation isn’t really an emergency after all. Putting an emergency expense on a credit card is way too easy because it feels more financially distant and less tangible than dipping into a sum of money you have worked hard to save up. I can’t prove it, but I’m inclined to believe that just having an emergency fund prevents emergencies.
Avoid tailspin of repeated failure
Unplanned expenses come up for all of us who can’t see the future. Without an emergency fund, our only line of defense against these emergencies is a credit card. Getting into new debt while trying to get out of old debt is terribly discouraging. Feeling defeated leads to letting other expenses slide as “emergencies” and before long you’re worse off than when you started. All those failures, even if they were not individually large financial blows, add up to paralyzing discouragement.
Are you convinced about having an emergency fund before tackling debt?
Are you with me? Before you go all out and tackle your debt, are you going to save up some emergency funds?
Now that we agree that an emergency fund is a wise idea, let’s talk about how to build an emergency fund, how much it should be, and where you should keep it.
Build your emergency fund
There are essentially two ways to build an emergency fund: save more and earn more. Or you could wait for a windfall, but I don’t advise that. If you are expecting a tax refund, however, socking it away for true emergencies would be a great idea.
I like to start with saving money. If you have leaks in your budget and you aren’t spending your money wisely, making more money won’t improve your money management skills. This is precisely why I wrote Frugal Fresh Start. Decreasing your expenses and optimizing your budget will go a long way.
With a functional, optimized budget and reduced expenses, all the extra money you earn will be put to good use. The extra money you earn won’t get lost in your budget or go toward lifestyle inflation, but will be put to good use: first to build your emergency fund, then to pay off debt.
How much do you need in your emergency fund?
Just to be clear, we’re talking about an emergency fund during debt payoff. Once your debt is paid off, you will likely opt for a larger emergency fund. A standard starting point for an emergency fund is $1,000, though for most people that is on the low side. For anyone like us with an older car, pretty much anything that can go wrong with your car could cost you more than that.
I can’t tell you what the right number is for you. You’ll want to consider factors like what your “emergencies” have looked like in the past and how much your normal expenses total for a month. The size of your emergency fund will also depend on how long you expect your debt payoff to take. If you anticipate a longer debt payoff time frame, you’ll want to have more saved. Choose a number that you are comfortable with. There’s no right answer.
Personally, we kept around $5,000 in our emergency fund while paying off debt. Even though we didn’t have to worry about any housing expenses (we were living in my in-laws’ unfinished basement during our debt payoff), we both drove (and still drive) older vehicles and at the time had three to four children.
Where do you keep an emergency fund?
An emergency fund should be liquid. In other words, you don’t want your money tied up in investments. It should be easy to access. At the same time, you don’t want your emergency fund too easy to access, especially if you aren’t very financially disciplined.
We kept our emergency fund in an online savings account during our debt payoff. While our emergency fund didn’t make tons of interest, it also didn’t cost us anything since there were no fees or minimum balances.
It’s worth it!
If you’re looking solely at the numbers, then taking time to save up an emergency fund before starting to pay off debt will result in an imperfect maximization of funds. However, for us humans, the peace that comes with having money earmarked for emergencies is priceless. Knowing that you have money to fall back on should a large unforeseen expense arise allows you to give your all to paying off debt. You can move forward with your payoff plan without getting sidetracked by the risk of additional debt and its degrading effects on your financial morale.
How About You?
- Would you consider tackling your debt without an emergency fund in place?
- How much of an emergency fund do you feel comfortable with during your debt payoff?
I just consolidated my credit card debt into a personal loan at a lower interest rate than any of my credit cards. I’ve set up a small automatic payment on the cards (along with autopay from by bank account to immediately pay them off) to keep them open.
Right now, it looks like a LONG road ahead. I don’t have emergency savings. I always thought my credit cards were my emergency money, but I’m not making as much after relocating from NYC, so I needed a tighter budget, and a fixed interest rate so my interest charges stop undoing the payments I’m making on cards.
I’m saving for an emergency fund simultaneously while paying off my personal loan. I also have a part time job (in addition to my full time job, and I’m hoping to get a second part time job), so I can pay a little extra off of my personal loan. I’m also hoping I get a large tax refund, so I can pay a bunch on the loan from that too. It’s not as fun as other ways I could spend that money, but the sooner I pay off that loan, the sooner I have that money freed up for more savings.
Right now, it’s just budgeting, loan payment and emergency savings fund. I got an AmEx Bluebird card for our vacation fund money, since travelling is very important to us. I pack my lunch, we don’t go to the movies or eat out as much (and I’m hoping a third job at the movie theater will get us free movies so we can save on that too!). I’m eager to be done with my loan repayment so I can save for things we want in the near future like a house, our kids, and more funds towards retirement. It seems like SOOO much money is needed for anything, but this blog is helping calm my nerves. 🙂
I agree with your weighting of the psychological benefit versus the best utilization of funds. Plus, it’s always been my belief that having an emergency fund actually saves money in the end. Taking care of a cavity when it occurs is much less expensive than waiting and needing a root canal and crown a year later when part of the tooth breaks away. Knowing that you’re going to need new tires in a few months and purchasing them when you see a good sale is less expensive than waiting until you’re running on the rims and have to buy whatever you can find, sale or not.
An emergency fund gives me piece of mind! In 2008 I had a medical leave from work which resulted in foreclosure. I went back to work and bought a mobile home and got a high interest loan. I’ve been paying off the principle every month while also adding to the emergency fund. It’s slow going but as the emergency fund balance grows and the amount I owe on the house shrinks, it gives me the encouragement to keep going. I work overtime whenever it’s offered, and that extra money goes to the the principle on the loan and to the emergency fund. It takes patience and perseverance. I think it’s very important to start the emergency fund first, and keep adding to it, even if you can only add $25 a paycheck, it all adds up!
Glad you mentioned the emergency fund portion of paying off debt! And it is often discouraged in getting out of debt even by debt advisers! Even if you have a tight budget cutting back something to save even $25 a week is a start. There is something about having a ‘net’ that can ease anxiety. We get all our banking free of charge (I’m from Canada so it’s not available to USA, sorry lol!) but I still put our emergency fund in a delayed transfer savings account. If we want money from it it can only be transferred to our main account (online) and won’t be accessible until the next day.
I couldn’t imagine increasing debt to cover an emergency! When we combined a small LOC with our house mortgage to get half the interest rate (yes, we closed the LOC ha ha!) I was surprised at how much it upset me to see our mortgage balance go up even though our total debt went down (with the reduced interest rate). I couldn’t imagine doing that during an emergency situation when you may already have heightened emotions about the emergency!
Good point Tamaira! Even on a tight budget, you can probably sock away something.
I totally think an emergency fund is necessary – ours is about one month’s worth of expenses right now, but I don’t know if we should make it higher. We just finished our taxes and are getting a decent return which I planned on putting mostly toward student loans, but I wonder sometimes if we should. As homeowners, something major could always come up.
That’s a tough one Jenni. Owning a home does often have those fun surprises. I think it’s wise to have more when you know your projected payoff date is further away. Between a family and a home, there’s a lot that could happen. Another layer of security for us is our debt payments themselves. Since we don’t have anything due (thanks to IBR), if something comes up we can always just not pay as much toward debt. If you are in a place where you are consistently overpaying on your debt, this might be a nice buffer against those “surprises.”
I completely agree. An emergency fund is extremely important and definitely eases the mind. Having said that, I do not have an emergency fund. Not a single dollar. But hear me out…..I don’t own a house, I don’t have children, and my car has less than 25,000 miles on it. My student loan payment is actually zero and I put around $2000 on it a month. That’s my emergency fund. If I do end up needing brakes for my car or God forbid a medical expense, I just won’t pay my student loan that month. Three more payments and that loan will be gone! My next step, I promise, is my emergency fund!
I totally get that Tracie! We are in a similar situation (not having any minimum due on student loans right now). It’s nice to know that if something crazy were to come up, we could always just pay less toward debt the following month.
Keep up the good work! You are so CLOSE!!
Another emergency strategy – we keep our mortgage pre-paid by 2 months (actual payments, not just paying down the principle). The mortgage would be our biggest expense out of our emergency fund if something happened. It gives us a bit more time to come up with plan B if we have no income. Plus since the money is “gone” (but still doing good), it won’t be sitting there tempting us in the emergency fund account. Our bank gets confused if we do more than 2 pre-payments else we would probably try to do a few more pre-pays.
This is a really good tip – a mortgage is one of those things that is not as flexible in an emergency as other things (you can always get food stamps in pinch, but not housing stamps!). I’m going to look into paying ahead on our mortgage to see if that is even possible.
I like this strategy Amy!! That’s a great idea!
Okay, here’s our story, in 2010, we had an emergency fund of $1,000 while we paid off our debt. We were highly motivated to pay off our debt crazy fast because we had such a small emergency fund! It was scary and motivating at the same time! Really! I don’t believe we would have made the initial progress we did without that emergency fund as a safety net.
A little background, in September 2009, the day after we had depleted most of our savings paying for work done to our house, the company my husband worked for put everyone on half pay temporarily…then no pay. It was very uncomfortable as we drained our remaining savings to zero. I remember paying for groceries with a credit card which I had never done before. During that period of time, I got my husband to read The Total Money Makeover by Dave Ramsey and we had a lot of discussions. We agreed we would follow the 7 baby steps plan detailed in the book and get out of debt – he landed a temporary contract job that became a permanent position and his first paycheck in February funded our emergency fund and we started paying on our debts. (He got paid for his contract work many months after he became a permanent employee – there was some sort of accounting mix-up.) Fortunately, we never had to use our tiny emergency fund during the 9 months we snowballed our debt payments. Then we saved up for a 6 month emergency fund which took a while as we had a few emergencies during that period and afterwards and we’ve had to dip into it several times – always refilling it back up so it would be there. And now at long last, we are finally in the home stretch of paying off our mortgage!
To everyone starting on their journey to payoff debt, save a starter emergency fund whether it is $1,000 or more. You will be so glad to have that emergency fund safety net when emergencies come up.
Thanks for sharing your story Midori! That’s so motivating to hear!
This is something that’s been on my mind lately. We’re just at the very beginning of the process having just set-up all our finances on YNAB ready for the first full monthly wage it come at the end of the month. I’m conscious of an emergency fund, true expenses that should be planned for and getting into a position to live off last months salary as you currently do, as well as starting to look more closely at increasing or starting payments on debts we’ve neglected. It’s a lot to think about at once. I’m going to have to prioritise. I’d be interested to know which order you think I should tackle these in?
Thanks
That’s a good question. I would build an emergency fund (size depends on what you’re comfortable with) before you start to throw extra at your debt. If you are in super debt payoff mode, you’ll be able to save for an emergency fund quickly. You need to be assertive about it (don’t just wait to passively save up an emergency fund). As for getting a month ahead, you could do that alongside paying extra on your debt, though there is some leeway in finding what it best for your own situation there. We took a couple months off from paying debt at the beginning of 2014 to get a month ahead. Since our debt has no minimum payments and we were in super debt payoff mode, it worked out well for us.
Very true and a step many people miss that avoids them getting back into the ‘cycle of doom’ once they’ve gotten themselves out.
We’ve actually reduced our emergency fund over the years, simply because now we have a mix of different assets and liquid funds that we could access if needed. As long as you’re covered, that’s the important thing.
I wish I read this article 3 years ago when I started to seriously paying off student loan debt! For the first year, we didn’t make great traction for two reasons: 1. We didn’t budget well enough for everyday costs like oil changes and haircuts and 2. We didn’t have an emergency fund so we kept on dipping into our debt repayment money for care repairs, etc! Now, I’m the same as you. My husband and look at our savings account and AVOID touching it at all costs. All of a sudden, my husband is googling home repairs and I’m making the most “creative” dinners you’ve ever seen the day before payday! 🙂
Love this Jane! Not only are you not dipping into your debt repayment money anymore because you have an emergency fun, but you’re making it getting creative and resourceful because you don’t want to have to use the emergency fund. We are the same way! 🙂