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Pay Down Debt or Build an Emergency Fund?

Although I’m not a financial professional and I don’t normally give advice, I’m relatively comfortable offering some opinions when it comes to strategy. A reader presented this question to me recently. I’m open to answering questions as long as the answers don’t involve giving stock picks or legal advice.

My wife and I recently moved across the country, going into debt in order to throw our lives into upheaval. We both have contract positions, so our income tends to fluctuate. At the moment, it’s steady, and we can pay our bills have some left over to pay off our debt. I’m concerned that this won’t always be the case and our income might drop, requiring us to live on credit again because we don’t have enough savings to cover our expenses other than savings accounts that have been designated for things, like taxes. I really want to get out of debt, though, and I’d like to put all of our extra income to paying off debt.

Being in debt can be demoralizing, especially for someone who has been reading at least one personal finance blog for several years (as I believe this reader has). In this case, we’re not dealing with debt that some might consider good, like student loan debt, or for some tricky manipulators, 0% balance transfers. Credit card debt for regular expenses, the type of debt that isn’t paid off immediately at the end of the month, is universally considered damaging to a family’s finances in the long term. Financial education creates a strong aversion to this type of debt.

Yet, attacking credit card debt with the full force of anything left over from a paycheck is not always a good thing. While the feeling of eliminating debt is great, without some cash ready to be deployed in the vent of an emergency, that credit card will return. For some people, emergencies just tend to keep happening, because anything you haven’t saved money for has become an emergency.

If there are savings accounts designated for other expenses, they could be usurped by a formal emergency fund for now, but if these cash accounts are being held for tax bills, as employers often don’t withhold taxes for consultants working independently, then it’s best to leave these accounts alone. If the savings is designated for a new camera or next year’s vacation to Cabo, the better financial decision is to shore up the emergency fund before using the money to head to the shore.

He’s a fan of the Balanced Money Formula, which suggests creating three buckets for after-tax income. 50% of the net income goes to “needs,” 30% to “wants,” and 20% to “savings.” In our discussion, the reader considered splitting the savings category into 10% savings (in the form of an emergency fund) and 10% paying off credit card debt. I originally placed debt under the savings banner when describing a method of budgeting based on Maslow’s Hierarchy of Needs, but that might not be appropriate.

The minimum monthly payment to credit cards must fall under “needs,” because if these payments are not met, the credit card issuer will penalize the borrower with higher interest rates. In the worst case scenario, the debt could go into collections and ruin the borrower’s credit rating. This is a costly mistake. But where do extra debt payments fall in?

When paying off high-interest credit card debt is a goal, it’s more important than wants. If you’re going with the Balanced Money Formula, debt elimination is a need or a want. If there is no existing emergency fund, the last 20% for contributing to a savings account should also be prioritized as a need, and this supersedes the need to pay extra money towards credit card debt beyond the minimum payments. If the only after-tax income you have after paying the necessary bills is less than the 50% for wants and savings, you’ll find that extra debt payments and building up a savings account compete for priority.

Starting the emergency fund should be the winner of that battle. At least get an emergency fund started with maybe $1,000, $2,000, or the cost of one month’s worth of expenses in the bank.

Once that has been accomplished, return to the Balanced Money Formula. At this point, you’d be able to pay down debt faster than the minimum payments alone while continuing to build an emergency fund.

Photo: peasap

Published or updated July 28, 2011.

About the author

Luke Landes is the founder of shizennougyou. He has been blogging and writing for the internet since 1995 and has been building online communities since 1991. Find out more about Luke Landes and follow him on Twitter. View all articles by .

{ 20 comments… read them below or add one }

avatar 1 Anonymous

Having at least $1000 in an emergency fund is pretty essential. After that whether you pay down debt or build savings depends on the situation.

I also like the Balanced Money Formula a lot. I think thats a great way to go about budgetting. Of course you may want to adjust the %’s a little for your unique situation. Like if your income is fairly low then you may realistically need a higher % for ‘needs’ than the base amount they give.

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avatar 2 tigernicole86

I have to agree with Jim on this one. I’ve got my student loan debt which for me, I’ll like have paid off before the 10 year period(probably only saving me a few hundred but hey, it’s a few hundred!). But I hate to know that I have to pick savings this month or paying extra on loans.

I’ve found that putting a picture of something I’m saving for in my wallet helps me put off those little things I want now. Helps build up the EF and helps with the goal savings. =D

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avatar 3 Anonymous

The balanced money formula is good in theory, but most people don’t need 50% of their income to fulfill needs. I cover both needs and wants on 75% of my income, and that covers a family of 4. I’m paid well, but I find most people don’t really know what “needs” are. Shelter, but not a huge house. Food, but not restaurants and convenience foods. Companionship – which is mostly free.

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avatar 4 Anonymous

I would suggest that they cut expenses to direct extra money into an emergency fund of 1-2 months of expenses (while still paying minimums) and then focus on debt repayment. The problem with a fluctuating income is that your have to create the stability and safety your employer isn’t providing. My opinion is that achieving that stability, 4-6 months of expenses in the bank and knowing that you can pay more than the minimum on your debts each month, is a really important goal to achieve and it’s the only way you can be sure to get out of debt.

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avatar 5 Anonymous

If their income is fluctuating they need to budget based on the average, not what they’re making right this second. (Even better would be to budget based on the minimum.) Imagine working as a teacher and getting only 10 paychecks per year. The 1/6th of each paycheck you put into savings isn’t your “emergency fund,” it’s your living expenses for the paycheckless summer. The OP’s situation is similar, but with randomness and uncertainty to how many and how large of paychecks they will receive. So it seems to me they possibly need to reduce their living expenses.

That said: even if they are sure that their pay will drop again in the near future, it may still make sense to pay off their credit card debt. At least that way they save a few months of double-digit interest charges on the money. The only exception is if their existing debt is at a teaser rate, and new debt would be at double digits. If they are less than 50% certain their income will drop, it makes even more sense to pay it off now, even if they end up reacquiring debt in the future.

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avatar 6 wylerassociate

I would focus on paying off my debt first then work on building the emergency fund.

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avatar 7 Anonymous

Sorry, but I think that’s asking for trouble. Q: Would you rather owe $10,000 and have $10,000 in the bank OR owe nothing and have nothing in the bank? I’ll take the former every time.

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avatar 8 lynn

I agree with Andrew on this one. There’s nothing like the freedom from debt.

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avatar 9 qixx

Choosing this route is just like the gamble of not having life insurance. Do you bet on yourself or against yourself. If you don’t have insurance than i say pay off the debt first. Should you have life insurance and an emergency fund. Absolutely. Should you have it first? That one i think you should decide on how comfortable you are with risk. I think the majority should have the emergency fund before paying off debt. If you decide debt before emergency fund, and an emergency happens, you better move that emergency fund up to number one. If no emergency then you gambled an won.

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avatar 10 Anonymous

Financially, it’s more important to pay off debt than to create an emergency fund. Emotionally, an emergency fund is what most people want.

Really, it makes no sense to tie up a few hundred dollars in a bank account paying 1/2 to 1/10 % when you have bills that you are paying 30% on. And if you have an emergency, put it on the card, and continue with your paydown strategy. But you really really have to decide what is an emergency. A broken-down car that is used for work is an emergency. A broken-down dishwasher is not. You are trading inconvenience for cash. And, in light of that emergency, do you really gotta have the “small” indulgences every month that you’ve convinced yourself you gotta have to keep yourself sane?

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avatar 11 Anonymous

They need to have a hard look at their expenses and find places where they can cut. They also need to take a look at their average income over a set amount of years. I also live on a fluctuating income and just because you’re rolling in the dough one year, doesn’t mean that will repeat itself the next. I’d say save up at least $2,000 in an ER fund, then focus on paying off that debt.

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avatar 12 shellye

They should save up $1000 in an emergency fund, then pay off the debt. I don’t understand why people think it’s better to build up $5k or $10k in an emergency fund that will pay at best, probably .25% in some passbook savings account somewhere, than to pay 14.99% on average, on credit card debt. You can’t earn 14.99% on investments anywhere these days, so get the debt paid off and it will be like paying yourself.

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avatar 13 Anonymous

I find it interesting that people keep saying “I’d rather have so much cash rather than paying off the debt”. BUT WHY?? It makes no sense financially to have any cash. If you have a $500 emergency and you only have $250 saved up, you are still going to have to use the credit card. So why keep any cash at all?? As long as you have credit card debt that you are paying on, you should put all your cash on the debt.

Of course, there are probably things you can’t pay with a credit card and it makes sense to have some cash for those needs, especially since you get hit with a 3 to 5% fee for taking cash from your credit card. The only other reason for having cash is that warm fuzzy feeling you get not having to put purchases on a credit card.

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avatar 14 Anonymous

No. You need the cash. The credit card company can close your account at any time they chose to. I went through a period of unemployemnt. I had around $10,000 in my checking account and I continued to use my credit card, but instead of paying it off every month as I did before being laid off (and as I do again now), I paid the minimum. Eventually I was in a position of owing as much as I had in the bank, but there was to reason to panic B/C I STILL HAD PLENTY OF CASH. That allowed me to continue to look for the right job and not just take anything that came along.

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avatar 15 Anonymous

I am of the mind of building up 1k to 2k emergency fund then aggressively attacking debt. Personal finance is first and foremost personal. Some people need that emotion security of having a little cash in the bank, jar, or mattress.

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avatar 16 lynn

Dave is very wise in his line of thinking.

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avatar 17 skylog

everyone is either in one camp or the other on this one, and i am camping with dave and lynn (and others). while i see the point of going after the debt without the EF, i feel the EF is needed as insurance. there are just too many things that can come up that the cash could be needed for.

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avatar 18 Cejay

My brother lives with us since he had lost his job and was unemployed for a year. Then he had a sudden illness last year. We keep telling him to set aside as much as he can the first few weeks for an emergency fund and then to hit those bills hard. He never listens and each time something happens, one of his daughters gets sick, his car need works, or he is out of work for a week due to snow the credit card comes back out. He is getting nowhere and is getting frustrated. But he will not listen.

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avatar 19 Anonymous

My spouse and I recently discussed this same situation, and we decided to pay roughly twice the minimum monthly payments toward the credit cards (totaling about $250 a month) while saving the rest in a fund that to pay off our car loans, which would otherwise be paid off next January and July, respectively. The car loans are a drain of roughly $1,100 a month (hello, bad interest rates!), and the payment amounts can’t be changed from month to month, unlike the credit cards. If we pay the cars off early, future joint expenses will be easier to handle during a time of reduced income.

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avatar 20 Anonymous

I think it is more important to pay down your debt. Once you have that done and you’re no longer paying interest than you can start building the emergency fund.

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