Emergency funds are used to protect you when unexpected circumstances arise, but if you already have debt, should you wait to build an emergency fund vs. debt repayment?
On one hand, the emergency fund will ensure that you’re well set up for any future unexpected events. On the other hand, by waiting to pay off expensive debt you could be costing yourself in interest accrual. Both building an emergency fund and paying off debt are great for your financial health, but there’s never enough money to do both.
Which one you prioritize depends a lot on your individual circumstances.
Good Debt vs. Bad Debt
Now there are various camps on whether debt can be good, but there’s certainly some debt that is better.
Good debt is debt that you take on to help build wealth or improve your financial situation, and wouldn’t be able to achieve without debt. Some examples of good debt include a mortgage, student loans, and some car loans (this one has a big asterisk – you shouldn’t be buying more car than you need). These debts typically have a set payment every month, and the interest rates are not too crazy (<10%).
Bad debt includes debt that you have taken on for things you don’t need, or debt that has very high interest rates. Examples include credit card debt (when you carry a balance between billing cycles), borrowing money for furniture or applicances, or any other debt that was taken on unnecessarily. Generally, if the interest rate is greater than 10%, this is debt you want to pay down as soon as you can.
With that in mind, let’s explore when you should prioritize funding an emergency fund vs. debt repayment.
First Things First, Don’t Neglect Debt Obligations
Before we get into it, I want to highlight that I’m talking about allocating any surplus funds to emergency fund vs. debt repayment.
There should never be a circumstance where you don’t pay your mortgage in order to tackle other debt. Or where you skip a credit card payment to fill an emergency fund. Missing a payment can have a large effect on your credit score, and can cause hardship later on if you’re ever trying to qualify for new credit.
So track your expenses, take care of your financial obligations, and budget surplus money for either your emergency fund or debt repayment.
When You Should Prioritize Debt Repayment
When You’re Carrying Bad Debt
If you are carrying bad debt, you should prioritize paying it back before you start to build an emergency fund.
A big purpose of an emergency fund is to protect you from having to take on bad debt in the case of an emergency. But if you’re already in that situation, you should deal with that first. You should prioritize eliminating bad debt that is already present, rather than saving to prevent the potential for more bad debt in the future.
There’s no point in preventing something that is already present, deal with the issue first.
When You Need to Up Your Credit Score
By paying back credit, you can improve your credit utilization and debt-to-income ratio.
If you are looking at making a large purchase in the near future (e.g. a home), focusing on your credit may help get favorable mortgage rates. By paying back debt, you can reduce your credit utilization, which can increase your credit score. You can also decrease your debt-to-income ratio, which is a considerations for loan approval.
Depending on upcoming big purchases, it may make sense to focus on debt first before building up your emergency fund.
When You Should Prioritize an Emergency Fund
If you don’t already have an emergency fund, unless the above circumstances are true, you should be proritizing an emergency fund.
The whole point of an emergency fund is to prevent long-term damage to your financial situation caused by emergency expense. If you don’t have defenses in place (i.e. emergency fund), an emergency will force you to either take on (potentially bad) debt, or to fire-sales assets (e.g. withdraw money from your investing account). Both of these actions mean that on top of the actual emergency expense, you’re also paying for the interest – either on the loan, or foregone by interrupting investment compounding.
Once you’ve eliminated any bad debt, an emergency fund will prevent you from having to take it on again.
When Your Monthly Obligations are Manageable
If you’re only holding good debt (e.g. mortgage, student loans) and the payments are manageable, prioritize building an emergency fund over paying extra towards those debts.
By paying back these debts, your balance will go down, but so will your access to credit. Imagine you pay an extra $3,000 to your student loans, then you have an unexpected expense for that amount – they won’t let you re-borrow that money once you’ve paid it back. As such, if you don’t have defenses in place you’ll have to get a loan with higher interest rates (e.g. credit cards).
Continue to pay back your loans, but put any surplus towards protecting yourself in the future.
Emergency Fund Vs. Debt Repayment – Conclusion
Emergency funds are an important tool for financial health, and are great for preventing the need for bad debt. But deciding on an emergency fund vs. debt repayment is circumstantial.
If you already have bad debt, there’s no point in trying to prevent it in the future – deal with it before building an emergency fund. There may also be circumstances where paying back debt will improve your credit score in preparation for a large purchase.
In all other circumstances, put any surplus towards an emergency fund until you’ve hit your number. Continue to pay back your loans (e.g. mortgage, student loans), but don’t pay back any extra until your emergency fund is filled up. Once you get the bad debt out of your life, you never want to bring it back in, and an emergency fund can protect you.