Should You Start an Emergency Fund or Pay off Debt?

Which of these 3 options would be best for you?

You know it’s important to have an emergency fund to cover unexpected expenses, but you’d also like to pay off your debts as quickly as possible.

Is it a good idea to pay off your debts first before starting to save an emergency fund?

Or should you save an emergency fund while you pay your debts? Or even before you start reducing your debts?

The answer will depend partly on how many debts you have and the interest rates on those debts.

Here are three possible options for paying off debts and saving for an emergency fund.

Option 1: Pay off All Your Debt Before Building an Emergency Fund

Paying off all your debt before building an emergency fund could be a good option if you have high interest debts, such as credit cards and loans. If a lot of interest is being added to these debts each month, it makes sense to pay them off as quickly as possible.

If you already have enough money in savings to pay off some of your debt, it might be a good idea to do this. If the interest rate you’re paying on your debt is higher than the interest you’re receiving on your savings, you’ll be saving money overall if you use your savings to reduce your debt.

Don’t use all your savings to pay off debt, though. Keep some of your savings as an emergency fund and carry on building that up. If you don’t have a small yet growing emergency fund, you may need to use your credit card when an unexpected expense arises and this may lead to further debt.

Before deciding to pay off all your debt before building an emergency fund, see if you can transfer your credit card debt to a loan with a low interest rate. This will make it easier to pay off your debt because you’ll only have to make one payment a month and the interest rate will be lower.

Also, it might be possible to negotiate more favorable terms on some of your debts. For example, a creditor may agree to reduce the interest rate or even stop charging interest if you agree to pay a certain amount each month for a certain period of time. This could give you some breathing space during which you’d be able to reduce your other debts.

The main advantage of paying off your debt before building an emergency fund is that you’ll become debt-free more quickly because all your available spare cash will go towards paying off your debts.

The main disadvantage is that, if an unforeseen expense arises, you’ll probably have to resort to using your credit card or another form of borrowing to pay for it. This can be very discouraging after you’ve worked hard to reduce your debts.

Option 2: Saving for an Emergency Fund First While Making Minimum Payments on Debts

Another option is to prioritize building up an emergency fund while making only the minimum payments on each of your debts. The aim here is to build up an emergency fund that would cover one or more unforeseen expenses while you’re paying off your debts.

If you choose this option, it’s important to decide how much money you’ll save in your initial emergency fund and how long it’ll take you to save it.

American personal finance expert Dave Ramsey advises building up a US$1,000 (CHF 964) emergency fund before starting to pay off your debts.

Challenge yourself to save your initial emergency fund as quickly as possible so that your debts don’t increase very much at the same time.

This option may be a particularly good idea if you support one or more people financially and/or if you own your home. In these cases, having an emergency fund is more important than ever, so that you can continue to support your family and keep a roof over your head, should something unexpected happen.

The main advantage of this option is that, once you’ve saved an emergency fund of let’s say CHF 1,000, you’ll feel more confident about paying off your debts.

You’ll know that the money in your emergency fund is available to pay for whatever unexpected expense may arise. This will mean that you won’t have use your credit card in a crisis and you won’t have to slide further into debt.

The main disadvantage is that will take some time to save an emergency fund and during that time your debts will increase because of the extra interest. If you have mainly low interest debts, this shouldn’t be too much of a problem.

Option 3: Paying Off Debt and Building Up an Emergency Fund at the Same Time

The third option is to set up a debt repayment plan and an emergency fund savings plan at the same time.

First, decide which debt you’ll pay off first. This could be the debt with the highest interest rate or your smallest debt.

Write down how much money you’ll allocate to paying off this debt each month and add up the minimum monthly payments on your other debts.

Then, calculate much money you have left over after paying all your monthly expenses. Decide how much of this you’ll put into your emergency fund.

You may decide to put the majority of your available money towards paying off one or more debts, while adding a smaller amount to your emergency fund. Or you may decide it’s wiser to put more money into your emergency fund initially, while paying down one debt at a time.

Hopefully, when something unforeseen happens, you’ll have enough in your emergency fund to cover it in full or in part. This will help you feel that you haven’t slipped backwards and you’re well on your way towards become debt-free and less reliant on credit cards.

Conclusion

It’s always a good idea to have an emergency fund so that you don’t have to resort to using credit cards or other forms of borrowing to pay for unexpected expenses.

However, if you have a lot of high interest debts, focusing on paying them off as quickly as possible might be a better priority than building an emergency fund at the moment. This stops the debts from getting higher and higher each month with the addition of interest.

If you can, try to save at least a small emergency fund, either before or at the same time as paying off your debts.

Knowing that you’d be able to pay for the next unexpected expense that occurs will help you feel more confident financially. This feeling of confidence will help you to continue paying off your debts until you are debt-free.

By then, you’ll probably also have a healthy emergency fund, which you can then increase so that you’ll be able to survive any unexpected situation that life throws at you.