You’ve probably heard of something called an emergency fund, otherwise known as a “rainy day fund,” right? It is simply a bank account, usually a savings account, that you keep funds for emergency expenses that can knock you off your financial game. And while there are lots of differing opinions on how large it should be, the one thing almost everyone agrees on is that you should build an emergency fund, and that it is crucial for helping you handle a financial crisis. But for many folks, the question is whether you should build that emergency fund or pay off debt first? Which should you prioritize?
Sadly, many people find themselves in a vicious cycle of trying to pay off debt, only to get hit with a financial emergency that causes them to have to go further into debt. So how do you create an emergency fund while also paying off debt? It seems impossible to do both, right?
Building an emergency fund doesn’t have to be such a daunting task, nor do you have to stop making payments to your creditors while building an emergency fund. However, that’s not to say it will be easy, or that there is some magical quick fix. Like anything in life worth doing, it will take effort, discipline, and a good plan.
How to Build an Emergency Fund when Paying off Debt
The first thing to do is to change your perspective on money. You need to realize what frivolous purchases today cost you in the long-term, because let’s be honest, that is usually the root of the problem. Then, you need to start changing your spending habits to fit your new-found perspective. All the financial strategies in the world won’t help you if you can’t control your spending habits. So, I would start with a simple Thirty-day Financial Cleanse, which will get you started on the right track.
Once you have created a little extra room in your monthly budget, you will want to start by creating a basic emergency fund of $1000. Of course, you have to continue to pay the minimum payments on your all loans, including your credit cards, personal loans, mortgage, etc. Don’t stop making payments to your creditors, or your credit score will suffer, and extra interest and fees will start to build.
When looking for a place to start building this fund, you want to find a bank account that pays at least a little interest, but more importantly, is separate from your daily checking account. It needs to be set aside for emergencies so that you think long and hard before dipping into it. Don´t worry too much about the interest rate, since this account is not an investment. Think of it more as insurance against life´s little problems that come along. Speaking of insurance, you´ll also want to make sure the account is FDIC-insured, which protects your money in case the bank goes bankrupt. You can check out a good list of accounts here.
Once you have created this basic account, you can begin to focus on eliminating your debt. For this, I recommend that you choose between two excellent debt elimination strategies: either focus all your extra cash-flow on the debt with the highest interest rate, or focus on the debt with the lowest balance and “snowball” your payments (as Dave Ramsey recommends). However, while you are paying down the debt, also take a piece of your free cash-flow and continue to build your emergency fund. This process is simply a balancing act between paying off your debts and building the emergency fund.
Focus on a Higher Emergency Fund Balance Next
You can begin to balance both priorities once you have the basic emergency fund of $1,000, but I would still prioritize the emergency fund from here. Why? Because again, one surprise trip to the hospital or tire blow-out could set you back significantly. Worse, you could suddenly lose your job due to circumstances beyond your control. That’s why I recommend, as a next step, an emergency fund balance of at least one month of your take home pay. Let that be your next goal.
Don’t Forget the Interest Rate
Once you have at least one month of take home pay in your emergency fund, you have much more flexibility. From here, take a look at your interest rates. The higher your rates are, the more I would focus your efforts on debt repayment over the emergency fund. If you have high-interest debts such as payday loans or credit cards, obviously you would want to get rid of debt as fast as possible. In that case, you can shift your focus from the emergency fund, but I would not neglect it completely.
How Much is Enough for a Fully Funded Emergency Fund?
Experts disagree regarding how much you need to save in an emergency fund. Suze Orman feels you should save 8 months’ worth of expenses, but Dave Ramsey recommends 3-6 months (and most Certified Financial Planners agree.) There is no perfect answer to this question, but you can look at your individual circumstances and choose the amount that makes the most sense.
Here are a few questions to consider:
- Job situation — How secure is my income? Am I in an industry that often changes rapidly? Are there two incomes in the household, or are there kids and a spouse that rely on one income? Am I self-employed?
- Health — How often do the members of the household get sick?
- Investments — Are all my other investments tied up in stocks (which can swing wildly in value), or real estate (which can be hard to sell), or retirement plans (which have penalties and taxes if liquidated)?
Life is unpredictable. It has a habit of throwing unexpected expenses at different times. An emergency fund can be a lifesaver in these scenarios. But the trouble for most people is that they have debt they feel they need to get rid of first before building an emergency fund. If that’s you, I recommend trying to find a balance between the two priorities, with an emphasis on building at least one month of expenses in the emergency fund account first, before you funnel all your free cash-flow at paying down debt.