Should I Build an Emergency Fund or Pay Off Debt?

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The key to personal finance is spending less than you earn.

When you don’t, the result is debt. Debt is borrowing from your future self. It forces you to keep paying (extra) for things you’ve already bought.

The longer you carry your debt, the more interest you’ll pay.

Paying off debt is a huge win, but which should come first, paying off your debt, or building your savings?

Your First Priority: Spend Less, Earn More

Before we talk about what you do with the surplus when you are spending less than you earn, we need to make sure that you really are spending less than you earn.

This involves three things:

  • Tracking Your Spending
  • Practicing Frugality
  • Generating Income

Tracking Your Spending

Tracking your spending over time is the only way to really know if you are spending less than you earn.

You might object that this is work that you don’t want to do, and I would be fine with that. I used to track all of my spending the hard way, now I just let Personal Capital do all the work for me and I just check in on it every now and then.

Practice Frugality

When it comes to personal finance, you have two levers you can pull: Spend less, or earn more.

Maybe you’re saying to yourself, I don’t have to cut back my spending, I’ll just work on growing my income. Sorry, bad idea. Ultimately it’s your spending that got you into debt. If you don’t address it head on, it will just rise to meet your new level of income.

If you’ve been making $4,000 a month and spending all of it plus your $500 credit limit, you’re not suddenly going to be alright if you get a thousand dollar a month raise. Instead of holding your spending constant at $4,500 while repaying dent with the $500 surplus, you’ll increase your spending to $5,500.

You have to reign in your spending.

Start by slashing your monthly bills. Try saving money on food by cooking. If you’re up for it, you can even tackle some of the big wins like housing.

Generate Income

That being said, there are limits to how much you can cut your income but essentially no limits to how high you can grow it. Doubling your income may not be easy, but it’s way easier than slashing your spending all the way to zero.

You can go the career-ladder promotion route, or the side hustle route. However you want to do it, it will probably be hard work, but it will pay off over time.

Use The Outcome Report Card

Once you’re generating a monthly surplus, you’re ready to start either investing or paying off debt.

One way to look at this decision is that either option is better than doing nothing.

There’s a tool I invented called the outcome report card that helps me put into perspective how important a decision is. The idea is to imagine the range of possible outcomes and to assign a letter grade like you would get in school to the best and worst ones.

For instance, the decision of who you are going to marry is an A+/F decision. Get it right, and things will go very well for you. Get it badly wrong, and life will suck for a long time. The moral: don’t marry someone just because they’re attractive.

On the other hand, paying off debt or saving is an A+/A decision. Get it right, and your financial situation improves greatly. Get it wrong, and your financial situation still improves greatly.

Whenever you have an A+/A decision in front of you, take Ramit Sethi’s advice and don’t spend more than five minutes deciding. If you haven’t made a decision after five minutes, flip a coin.

But how should you think about making the decision during those five minutes? Here’s my take.

Pay Off Expensive Debt First

If you have credit card debt that you’re paying 15 or 20 percent on, you want to pay it off as quickly as possible.

A few years ago I was talking to a friend who had no emergency fund about paying off his credit cards. He said he wanted to play it safe by building his emergency fund. I told him his debt was already an emergency.

His objection was was what if he starts paying down his cards, but then something happens and there’s a major unexpected expense he has to pay. He has no emergency fund, so what is he going to do?

The important thing to keep in mind is that such an event would constitute a major setback to either plan.

If you had saved up an emergency fund it could get wiped out. If you were paying off debt, you’d go right back into debt.

To me, the difference is that you could get back into debt at a lower interest rate.

If you’re a home owner, you could open a home equity line of credit (HELOC) that’s there when you need it at a much lower interest rate than you get with credit cards. Just make sure there’s no initial minimum withdrawal.

Another option is to take advantage of a 0% APR introductory credit card to cover your emergency.

When you have high interest debt, the way to save the most money is to pay it off early.

The Compromise

The math favors paying off your debt. But personal finance isn’t just about dollars and cents. You’re a human being, and how you feel about those dollars and cents means more than you realize.

If you need to psychological safety net of a cash cushion, then pick a reasonable savings goal and then switch to paying off debt once you hit it.

Dave Ramsey is the most notoriously anti-debt personal finance guru out there, and even he says to save a $1,000 emergency fund before you start paying off debt.

I think $1,000 is the perfect target. You might object that $1,000 is a random number that we attach significance to because it’s a milestone in a base-10 system, but that’s exactly the point. We’re doing this to make you feel good. And I guarantee you that you feel better about $1,000 than you do about $983 even though objectively they’re very similar.

Final Thoughts

Here are the two best plans on my book:

Option 1: Start With Debt

  • Open a HELOC or credit account with 0% introductory rate as an “emergency fund”
  • Aggressively pay down debt
  • Start building your savings

Option 2: The Cash Cushion

  • Save towards a reasonable goal such as $1,000 for a baby emergency fund
  • Pay off debt
  • Come back and fully fund your emergency fund

As far as I can tell, both options get a grade of at least an “A” using the outcome report card. Don’t spend more than five minutes deciding. Make a decision today and take action.

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