Saving money vs. paying off debt: The debate is always raging. When you have to make the choice between blasting through debt and establishing precautionary funds in case of a financial emergency, the right course of action is rarely self-evident.
Debt can be a heavy burden detrimental to your present and future financial options. But without emergency funds, you risk plunging deeper into debt should a costly crisis arise. The truth is, how you allocate your money is contingent on a number of personal circumstances. There is no single correct answer to satisfy everyone’s needs.
There are two primary factors to consider when choosing the smartest route: Type of debt and susceptibility to disaster.
Type of Debt
Some debts are nastier than others. Credit card debt has earned a reputation for being a particularly cantankerous beast. With interest rates often exceeding 15%, credit cards can wreak havoc on your finances and credit score.
If the bulk of your debt stems from unpaid credit card purchases, you’ll probably want to start by paying those bills. Credit cards have much higher interest rates than savings accounts, so making savings deposits will do little to counterbalance the negative impact of your debt.
One exception is if you can get ahold of a credit card with a 0% purchase and transfer APR introductory period. If you’re not being charged interest, you might be able to take a little time to create an emergency fund before tackling your debt.
Related: When Should I Do a Balance Transfer?
Student loans and mortgages are another story. They generally charge interest rates significantly lower than credit cards, so a dollar of student loan debt costs you less than a dollar of credit card debt over time. And as long as you’re making your regular payments, “installment debt” actually helps your credit score.
Lenders fear excessive credit card usage, but admire people who have the persistence to pay off mortgages and student loans. You don’t need to rush yourself — make the minimum payments and use additional money to establish an emergency fund.
Susceptibility to Disaster
Some people just have all the bad luck. If there’s little black cloud hanging over your head, you’ll appreciate the security an emergency fund can offer. With an emergency fund, you’ll avoid incurring further debt should you need financial support during a crisis.
While we can never predict the future, we can look at our circumstances to determine the odds of suffering a financial disaster. Here are a few factors to look at when weighing the importance of an emergency fund:
- Job security. If your job is unstable or under threat, you should be prepared for unemployment.
- Family. How many people do you support? The more dependents you have, the more lives a mishap will affect.
- Housing. Do you rent an apartment or own a house? If the hot water tank needs to be replaced or a tree falls through your roof, will you be responsible for paying the damages?
- Transportation. A person who drives an hour to work every day is far more likely to pay for car repairs or traffic tickets than a person who takes public transit. Further, every vehicle you add to your family multiplies the odds of unforeseen auto expenses.
- Health. Bad health is expensive and often unpredictable. How likely are you or your family to incur medical bills? How much will your health insurance cover?
A person who fears for his job, has eight kids, owns an old house in a rough neighborhood, drives a beater to work and has been in and out of hospitals for the past decade should probably have a larger emergency fund. A person who is firmly rooted in a secure and promising job, is single and child-free, rents, walks to work and rarely requires so much as an aspirin could be okay with a much smaller emergency fund.
When it comes down to it, you have three options:
- Pay off your debt and forgo the emergency fund
- Wait to pay off your debt until you’ve established an emergency fund
- Work on both simultaneously
If you have heavy credit card debt, focus on paying it off. If your life is fraught with financial risk, focus on establishing an emergency fund. If you have both credit card debt and a high probability of catastrophe, divide up your money and work toward both goals simultaneously. It’s a little like gambling, but if you know the odds, you can minimize your losses.