Those dedicated to strengthening their financial situation often find themselves facing the decision of paying off debt or building a large emergency fund. There are benefits to both, and the final decision will ultimately be based on your personal preference, risk tolerance, and priorities.
Benefits of Paying off Debt First
- You free up income
- The burden of debt is lifted
- Usually leads to higher credit score which can lead to lower insurance premiums
- The math supports paying off debt first as the interest of most debt is higher than the APY of savings accounts
Build Savings First
- Security against unforeseen circumstances
- Buffer in case income source is reduced or terminated
- Peace of mind
No matter what you decide, at the very least a minimal cash reserve should be set aside. Should you grow this to 6-8 months of expenses while paying the minimum on debt? Or should you throw everything you can at debt while slowing down, if not stopping your emergency savings funding? Once you begin to annihilate debt it can become very tempting to throw every penny towards debt reduction, however you’ll want to make sure you are not putting yourself in a position to use credit as a crutch should your income cease or decrease.
Take this short quiz to help you decide if you should build up savings or pay off debt. This is not a scientific quiz, for entertainment purposes only. As always, you should consult a financial professional before making any major decisions.
1. Describe your househould income: a. Single Income (1) b. Dual Income (2)
2. Describe your job: a. Irregular salary (1) b. Regular salary (2)
3. Do you have dependents? a. Yes (0) b. No (1)
4. Do you have multiple steams of income? a. Yes (2) b. No (1)
5. If you lose your job or primary source of income, how long would it take you to replace it? a. 0-3 months (2) b 4-6 months (1) c. 6-12 months (0)
Add up the points corresponding with your answer. If you scored:
Between 3-5 points: You may want to err on the side of caution and build a larger emergency fund. Your financial situation is somewhat volatile and an unforseen disturbance may make it difficult to rebound.
6 points: You’re in the middle of the road and could sway either way. You have enough liberty to focus on debt payoff, however stashing a little more in savings wouldn’t hurt either.
Between 7-9 points: You have enough freedom to attack debt. Your diverse income gives you enough flexibility to adapt and adjust as necessary.
I’ve used a modified Total Money Makeover approach. Dave Ramsey suggests saving $1,000 minimum, then attacking debt. My risk tolerance is not high enough for that, so I opted for a larger emergency fund before I shifted my focus to OPERATION DESTROY DEBT. I still fund the emergeny savings, but not with as much intensity until debt is eliminated.
What about you? What’s your strategy? What’s your outcome according to the quiz? What other questions / factors would you add?