Emergency Fund or Pay off Debt: Which is Better?

Last Updated: March 11, 2024

Paying off your debt versus an emergency savings account

Disclaimer: We are not qualified legal or tax professionals and are not giving advice. Always speak with a qualified professional before making any legal or financial decisions.



In the face of financial uncertainty, the question of whether to prioritize building an emergency fund or paying off debt becomes more pressing than ever. It's a financial crossroads many of us face, with each path offering its own set of benefits and challenges.

On one hand, an emergency fund acts as a safety net, ready to catch us during unexpected financial downturns. On the other, paying off debt promises freedom from interest payments and a clear path to financial independence.But what if you didn't have to choose one over the other? What if there was a way to strategically balance both, ensuring your financial stability and progress towards debt-free living?

In this article, we dive into the nuances of managing an emergency fund alongside debt repayment, offering insights and strategies to help you make informed decisions that align with your financial goals. Join us as we learn how to do this common financial dilemma, paving the way for a more secure and prosperous financial future.

If you'd rather speak to a debt specialist now, click here for a free consultation.

What is an Emergency Fund?

An emergency fund is recommended by financial experts as a way to stay out of debt. If you're curious about how to begin, read our article on why you need an emergency fund and how to start one. The emergency savings can be used to live on if you lose your job, cover minor medical emergencies, or living expenses, or fix a water heater that decided not to work anymore.

Most experts recommend building an emergency fund balance of three to six months of living expenses. For most people, that is pretty impossible. Instead, set a goal of $1,000 and then rebuild it each time it drops below that level after an unexpected expense.

For some people, $1,000 is out of reach. Break it down to something more affordable, whether it is $85 a month or $5 a month. Even a small emergency fund can help your financial resilience.

Open separate savings account for your unexpected expenses and work out a budget that allows you to set aside payments into your emergency fund.

People without emergency funds can fall victim to car title loans or payday loans. These are short-term, very high-interest debts that should be avoided at all possible costs. They are just not worth the 400% interest that these companies can charge.

If you need more information on emergency savings, budgeting, and cutting expenses, click here.

How Much Should Your Emergency Fund Be?

Financial experts often recommend saving 3 to 6 months' worth of living expenses in your emergency fund. 

To estimate how much you need:

• Make a list of all your necessary monthly expenses like rent, groceries, utilities, etc.
• Tally up the total for one month.
• Multiply this number by 3-6 to get your target emergency fund size.

So if your monthly expenses are $2,000, your target would be $6,000-$12,000 saved.

Consider if you need more or less based on your situation:

• Less if you have other assets or income sources.
• More if your income fluctuates a lot or you are the sole provider for dependents.

Paying Off Credit Card Debt

Carrying credit card debt can sometimes make people a bit desperate. Each debt has an interest rate that adds to how much you owe. If you're wondering whether  you should pay off your credit card in full, it's essential to understand the implications. Debts like credit card balances "compound" the interest. This means that you pay interest on interest. And since credit cards are high-interest debt, you end up paying a lot.

Minimum monthly debt payments on credit cards make credit card companies a lot of money and cost you a lot of money. Our debt payoff calculator tool can help you with the numbers and different payoff scenarios.

Paying down debt can improve your credit score. Carrying a lot of credit card debt and missing payments immediately harms your credit rating. Discover more strategies with our guide on the best ways to pay off your credit cards.

Where Should You Keep Your Emergency Fund?

The best place to store emergency savings is in a high-yield savings account. Look for an account with a high APY (annual percentage yield), which shows how much interest it earns.

High-yield savings accounts allow you to withdraw money when needed, unlike less liquid options like retirement accounts. And they earn interest, helping your money grow faster than a normal savings account.

Aim for a high-yield savings account with an APY of at least 1% or more. Make sure you understand any withdrawal limits before opening an account.

Understand your credit score and what it means

We've mentioned credit scores several times, so let's look at your credit score more closely. This is going to be a quick look. Check out our debt relief blog for more in-depth information on your credit score by clicking here.

Five factors go into your credit score. In order of importance, these are:

1) Payment History (35%)

Basically, this means you pay your bills on time, every time. Lenders want to know that you are a good risk to lend money to and paying your bills on time is very important.

2) Credit Utilization Ratio (30%)

The credit utilization ratio looks at how much debt you have compared to how much revolving credit you have. As you pay down revolving debt, your credit score will increase as your credit utilization ratio decreases. The goal is a CUR of 30% or less. This is why paying down debt is important!

Determine your CUR by dividing how much debt you have on your cards by how much credit you have on your cards, then multiply that by 100 for a percentage.

3) Age of Credit (15%)

Lenders like to see a long credit history. The only way to increase this factor is through time passing.

4) Credit Mix (10%)

This involves having different kinds of credit on your credit report. This can include mortgage or student loans and auto loans along with credit cards. If you rent, you can add that history to your credit report so that you have more data.

Read more about Different Kinds of Debt

5) Recent Applications (10%)

Remember that credit card you got at the big box store for the discount on today's purchases? That application hurt your credit score a tiny bit. These hard inquiries or hard pulls signify that you are planning to take out more debt. Your entire credit report is released to the company. A soft pull like checks by potential landlords or employers won’t hurt your credit score.

Don't apply for or open many accounts just to have more credit cards available!

Some Other Factors

Some of the credit reporting bureaus use additional information like your profession and salary. The big three credit bureaus (Transunion, Experian, and Equifax) will have slightly different scores based on the difference in which creditor reports to whom and if they use additional factors.

Should you use your credit cards for all purchases?

There are some popular reasons to use your card as long as you pay off your balance.

Here are some:

• Building Your Credit
• Security - with a credit card, you do not need to carry a lot of cash
• Convenience - see above! You'll need a card for the airline, hotel, or rental car reservations
• Travel - credit cards are easier to carry than cash, and you can get it replaced if it gets stolen
• Consumer Protection - many credit cards offer warranties, price protection, travel protection, additional rental car insurance, or other protections on purchased items. Check your card to see what protections you are offered
• Rewards and Cash-back - if you can use the rewards, this is a good reason to use a card (but pay it off every month)
• Grace Period - the time between the charge on a card and when it starts to accrue interest. If you can pay off your card immediately and take advantage of the grace period, it makes sense to use the card.
• Online Shopping - Obviously, shopping online and using cash is very difficult. Consider a debit card with a daily spending limit set at your financial institution instead of a credit card.

How Credit Card Interest Rates Can Hurt You

Credit cards are basically high-interest debt. Let's take a look at how that debt adds up if you carry a balance from month to month.

Monthly Payments

Let's say you have a balance of $6,000 and you make the minimum payments, of roughly $120 a month. Understanding debt solutions and monthly payments can help you make informed decisions about managing your debt. It will take you 8 years to pay off the debt, and the high interest means you will pay $11,352 total.

• Credit card balance: $6,000
• Current rate: 18.24%
• Payment: $120
• Time to debt free: 95 months (almost 8 years)
• Interest paid: $5,352
• Total paid: $11,352

Not running up your credit cards is very important.  Paying them down is equally important. If you're on a tight budget, you might be wondering how to pay off credit card debt effectively. Let's take the same situation but consider doubling the payments.

Double the Monthly Payments

As you can see in this example, you decrease the amount of time to pay off your debt and the total paid. If you can, it is worth paying extra each month.

• Credit card balance: $6,000
• Current rate: 18.24%
• Doubled payment: $240
• Time to pay off: 32 months (almost 3 years)
• Interest Paid $1,605
• Total paid: $7,605

Putting It Together

Deciding on which to do first - emergency fund or pay off debt - often leads to the question of emergency fund vs paying off debt: which strategy is more beneficial for your financial health? While some might suggest that paying off debt is the most important, an emergency fund can keep you from going deeper into debt. It's not necessarily a choice of one over the other; ideally, you should aim to balance both.

Budgeting

Your first step is to set up a budget. You may have to make sacrifices to build an emergency fund and pay off debt. For more guidance, check out these tips on how to pay off debts and achieve financial freedom. These short-term sacrifices will be worth the effort.

Keep an eye on your spending habits with your budget.

Set Up a Savings Account

Set up a separate savings account for your emergency fund and trickle money into it. If you receive unexpected money, put part of it into your emergency fund and keep it at $1,000. If you can, work on building the amount to cover several months of living expenses.

If you get enough built up, you may be able to open a high-yield savings account that offers high-interest dividends on your balance.

Control Your Credit Card Usage

Put away your credit cards and follow the following rules:

• Use a card for emergencies only and then pay it off from your emergency account
• Pay off your balance in full every month
• Avoid using your card for luxury items that you can't afford

Pay Off Debt

As you control your credit card usage and build up your emergency fund, you can start to pay off debt. There is no one way to do it so we will look at all the options. Avoid taking on any new debt!

Divide any extra income between your emergency fund and your debts.

The Best Ways to Pay Off Debt

Most people do not have extra money to apply to the entire balance, especially if they have multiple debt sources. To make payments you may need to budget, sacrifice, and focus on your repayment plans!

You need to keep payments on your needs (mortgage/rent, auto loans, etc) current while you aggressively pay down the debt.

Let's take a look at each different debt repayment method.

The Avalanche Method

In this repayment plan, prioritize paying the smallest balance first. Once that is paid off, that payment is then added to the payment of the second smallest balance.

You must be able to make more than the minimum payment on the lowest balance debt while making make minimum payments on the largest debt balances.

The Snowball Method

In this method, you focus on paying off the highest interest rate first. Once that one is paid off, you focus on the second-highest interest rate. Once you get to the lower-interest- debts, the payoff goes fairly quickly.

If you run to compare the snowball and avalanche methods using a snowball and avalanche calculator, there is usually not a huge difference in which pays off debt faster and keeps interest charges low. If immediate success inspires you, go with the avalanche method.

Balance transfer credit card

A balance transfer credit card lets you transfer high-interest credit card debt to a balance transfer card with low or 0% APR (annual percentage rate). Once the introductory period ends, the interest rates can be very high.

If you have the plan to pay off 100% of your balance transfer credit card within the promotional period, this may be a good option.

Debt consolidation loan

A debt consolidation loan is an unsecured personal loan or a home equity loan that you take out to pay off the cards. You then focus on paying off the loan until you are debt free.

This method works if you can qualify for a personal loan that has less interest than your bills. The monthly payments should be lower than what you currently have. You must also have a good credit score in order to be able to get the best loan terms.

Could a Debt Consolidation Loan Help?

If you have high-interest debts like credit cards, a debt consolidation loan may help you pay them off faster. This type of personal loan lets you consolidate multiple debts into one monthly payment at a lower interest rate.

The benefits are getting a lower monthly payment and saving on interest charges over time. Just beware of consolidation loans with high or variable interest rates. And make sure your credit score is high enough to qualify for the best terms.

Debt Settlement

Debt Settlement is usually conducted through a professional debt settlement company like Pacific Debt Relief. If you're overwhelmed with debt, you might want to consider using a debt relief program to help manage and reduce your obligations. In this method, you stop paying your unsecured bills while building up a savings account. The debt settlement company negotiates with each creditor and as the creditor settles, is paid off. The length of time depends on how much debt you have enrolled.

This method has two major drawbacks. The first is that it may damage your score. The second is that the IRS may view the settlement as income and you may end up with a substantial tax bill. For these reasons, debt settlement could be a final step before filing for bankruptcy. Our California Debt Relief initiative could be a final step before filing for bankruptcy

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