Emergency fund vs. debt snowball: What’s the top priority?
A few weeks ago, in my review of Mary Hunt's Debt-Proof Your Marriage, I mentioned that she advocates building a 3-6 month emergency fund before beginning to snowball your debt payments. That's not my approach, and I criticized it a little in my review.
Several commenters said they agreed with Hunt — that an emergency fund should trump debt repayment. It's an interesting issue, so I figured I'd explore both sides of it in a little more depth.
The Case for an Emergency Fund
The primary case for an emergency fund is simple: Having savings helps you break the cycle of debt. When your car breaks down, you won't have to rely on a credit card to get your wheels back on the road. You'll have your own savings to fall back on.
There's also a more subtle reason to do it. Saving money is at least as much about your state of mind as it is about your income and expenses. If you can get into the habit of saving a chunk of your income — 10% to 20% is what most experts recommend — you'll be well on the road to financial health. Adopting the “pay yourself first” strategy is one of the keys to personal finance.
Treating your credit card bills like any other household expense while paying yourself first makes good psychological sense. But you'll pay for it with interest.
The Case for the Debt Snowball
If, instead of putting your eggs into your own basket, you pay off your debts faster, you pay less interest on those debts. Even the best high-interest savings account is unlikely to get you an interest rate anywhere close to what your credit card charges. Odds are good that the interest you pay on those card balances is a whole order of magnitude greater than the interest you earn on your savings.
Over your lifetime, that means you'll have more total money if you pay off the high-interest debt first and then build up your savings.
But that only works if you get out of debt and stay out of debt. If small emergencies force you to break out your plastic every couple of months, you may just be treading water instead of turning the tide.
Taking the Middle Road
One good approach is to take a hybrid of these two: Build a small emergency fund first, and then pay down your debts as aggressively as possible. Dave Ramsey recommends putting $1,000 into savings before tackling debt. What you want is enough to cover a small emergency like a car repair or a plane ticket, but not a full 3-6 months of living expenses.
This is essentially what I did last year. I saved $1,000 in a savings account, and then began snowballing my debts. I also used the increase in our income after I returned to work to feed that debt snowball, and was able to repay a lot of debt fairly quickly.
Building up a small emergency fund and then aggressively paying off debts seems like a good middle road, but it's not without potholes.
At the beginning of our debt-payoff period, my husband and I weren't quite on the same page about our financial changes. Neither of us was used to living within our means. It was a great idea, but it took some practice to get good at tracking our spending and sticking to our budget. There were times we'd come up short at the end of the month.
Having a small emergency fund sitting there was like a fight waiting to happen. Couldn't we just take the money out of savings to cover this plane ticket? Or that gymnastics class? It turned out that, at the beginning of our debt repayment, we hadn't moved into the mindset of saving yet!
For us, paying off the debts faster and staying in the risky position of having no safety net worked better psychologically. Paying off debt was something we could agree on. And once the money had been sent to the credit card company, there was no bickering over what to do with it.
Handling Emergencies Without a Full Emergency Fund
You can't plan for emergencies; that's the nature of them. You can find creative ways to handle them, though. While my emergency fund hasn't grown beyond that initial $1,000, I've been able to handle all of the small emergencies that have come up in the past year without taking on any new debt.
One thing I've found is that, as my expenses have dropped and my income has increased, I have more money available. Most months, I use it to pay down our debts. When an unusual expense crops up, I can dip into my debt snowball to cover it. I've never had to touch our emergency fund yet.
This month, for example, my laptop needed major repairs. I could have tapped my emergency fund for the $300 to cover it, but instead I took it out of my regular checking account and simply scaled back my debt snowball a little (though not by $300; I also took money out of my entertainment budget to cover this).
Do What Works for You
Having a small savings fund to draw upon is definitely key to breaking the cycle of debt. You need to create enough of a buffer in your budget to absorb hits like car repairs, appliances breaking down, and health issues cropping up.
Beyond that, you need to do what works for you. If establishing the habit of “paying yourself first” is your top priority, setting up a weekly savings deposit and building that emergency fund might be your best course, even though it means paying a little more in interest over your lifetime.
If you're completely driven to get out of debt, you may do better to snowball your debts first and pay them off fast.
Ultimately, you need to do both: Eliminate your consumer debt and build an emergency fund. The order you do these steps in matters less than living out a commitment to establishing sound financial health.