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.
My Strategy:
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?
{ 14 comments… read them below or add one }
With the state of the economy, I would feel far more comfortable knowing I had a little nestegg in place, just in case! Then, once the emergency fund has been established, you can feel more confident making larger debt payments knowing it’s not money you may potentially need to get you through a rough spot. For more information on emergency savings, check out http://www.clearpointcreditcounselingsolutions.org/tips-and-tools/articles-and-tips/budgeting-articles/saving-now-pays-off-later-emergency-savings/.
I’ve been wrestling with this myself. I hate having debt, but would like more in savings given the current economic and unemployment rate. The fact that I have 4 dependents and we are living on a single income should push me more towards the savings side of the fence, but I feel my job is pretty secure and I just want to finally be able to pay off the car and student loans.
I like your point system for helping to decide, but I came up with “6”, which is middle of the road! LOL!
Guess I’ll keep on keeping on for now. 🙂
Great post, we don’t feel totally comfortable with just $1k so we’re going to bump it up to 3-6 mo emergency fund and then attack the remaining debt which are the student loans and they’re going to take some serious time to eliminate.
I agree — Build Savings First (for contingencies) — Then pay off debts — Then Invest — Then Spend.Nice post.
I completely agree. I went with a slightly modified version of Dave’s plan. $1000 was quite enough to make us comfortable so we went with about $2500. I could have probably gone with a little smaller fund, but this is what my wife and I were comfortable with.
.-= Derek – ChristianCommonCents´s last blog ..How My Emergency Fund Saved My Honeymoon From Total Disaster =-.
Lakita- I like how you bring the risk tolerance into this and I’m glad it’s more on the conservative side and not on the side that say “forget savings, I’m paying off debt!” I’m huge on sticking with Baby Step #1 (saving $1000) because it’s literally a life changer for most people and then attacking the debt with everything you’ve got!
Do you remember the time when 3 months of living expenses was considered safe?
.-= Carlos Frank´s last blog ..I’m Sorry but Stewardship is not just about Management =-.
Wonderful summary of Dave Ramsey’s plan. Like you said, it is all about personal preference. I prefer to be out of debt and have money. Both of these will be true if you follow this plan!
My opinion would be -pay off debt, with the assumption that one has an emergency fund. $1000.00 is the beginning point and gradually build it as you attack debt. This is the approach we have taken and right now we are out of credit card debt, paid off car notes.. and aggressively attacking our huge student loans.
The questions you posed are great way to check which direction to go.
Hello Lakita,
Many people ignore the upshot of accumulating debts. You did great pointing out this topic. credit-based life style is not the best.
.-= innocent´s last blog ..An Investor’s Strategy to Making Money Online =-.
With the credit lifestyle, you are at the mercy of the credit card company. Even with the new regulations, you may find yourself having to adjust at their whim.
I have a low threshold when it comes to financial security. That being said, when we attacked our consumer debt and started our snowball, we followed Dave’s method of $1000 emergency fund and even stopped our retirement contributions.
For us, it wasn’t about building up $1000 for an emergency fund, but rather, taking what liquid savings we had and putting it all toward debt. For me, that little savings account (which was more than $1000, though not by much) was my security, so putting it toward debt was my way of saying we are serious about getting rid of this debt once and for all and stopping this cycle of a credit-based lifestyle.
That being said, we started putting almost $2000 a month toward debt. So when we did have an emergency, in a way it was like we had a $3000 emergency fund instead of $1000, because all we had to do that month was halt our progress on debt and take care of the emergency. We cash-flowed some car repairs this way, for instance.
If our income vs. expenses weren’t such that allowed so much excess toward debt on a monthly basis, OR if my husband had any risk of being laid off (he’s military), I would probably want more cash set aside in an emergency account before going all out toward debt.
Fear can be a motivator! But it needs to be balanced with comfort level and common sense.
.-= Jolyn@Budgets are the New Black´s last blog ..5-goodwill-dress =-.
Good point! When you have a substantial amount going toward debt each month, you can always suspend that in case of emergency.
I think that is a great way to go about it. A lot of people stress out over the small emergency fund suggested by Mr. Ramsey. There is nothing wrong with building a little bit larger buffer before you attack you debt. Great approach.
.-= Kyle C.´s last blog ..Wealthy Bloggers – March 2010 =-.
Exactly! Dave’s advice is great and he has helped thousands get out of debt, but if you are going to be stressed, worried or uncomfortable….build more savings.
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