Should You Build an Emergency Fund or Pay Off Debt?

Deciding if you should save for an emergency fund or pay off debt can be tricky. On one hand, paying off debt could save you thousands in interest. On the other hand, failing to build your savings could force you into further debt if you encounter unexpected expenses.

Generally, building an emergency fund should be your priority. However, your personal financial situation will dictate when you should pay off debt or contribute to an emergency fund first.

When your emergency fund should be priority

You don’t have an emergency fund

Why is creating an emergency fund a top priority? Emergency savings help you cover a surprise expense without taking out high-interest debt. For example, if your car breaks down, it’s best to pay for the repair with cash rather than taking out debt that you’ll need to pay interest on.

Emergency funds also help keep you afloat during greater periods of distress. If you suddenly lose your job, you’ll have a safety net to help pay monthly expenses, such as rent and utilities. An emergency fund can help you avoid consequences like eviction, car repossession and utility disconnection.

You only have ‘good’ debt that doesn’t drain your finances

Debt that covers appreciating assets, such as a mortgage for a home purchase, is considered good debt. Some types of good debt include:

• Mortgage debt
• Student loans
• Short- to medium-length auto loans
• Credit card debt that you pay in full every month

While you should always make at least the minimum payment on all debts, it’s more important to start an emergency fund than it is to pay extra toward good debt like your mortgage or student loans.

You want to avoid new debt for a future expense

Planning for a large purchase by budgeting and paying in cash is a good way to avoid unnecessary debt and save money on interest. If possible, you should save money for large expenses, rather than paying extra toward existing debt first and then taking out debt again.

Of course, there are exceptions to this rule. For instance, it may be more productive to pay off high-interest revolving credit card debt rather than to save up for home renovations, which you might be able to finance on good terms using a home equity loan. Consider loan terms, such as interest rate and loan length, before deciding whether to save money or pay off debt.

When paying off debt should be priority

You have an immediate obligation to repay the debt

Paying a mortgage, auto loans and other debts that keep a roof over your head should always be your top priority. Never skip minimum monthly payments on debt in order to grow your emergency funds. Skipping debt payments could result in:

• Late fees
• Negatively impacted credit scores
• Debt in collections
• Seized property (in the case of secured loans)

Consider your loans and other necessary living expenses when building your budget. Money that falls outside of your “needs” can be used for savings or additional debt repayment.

You’re struggling to keep up with high-interest ‘bad’ debt

Paying down high-interest consumer debt should be your first priority if that debt is draining your income and keeping you from saving money. Bad debt siphons money from your monthly budget through interest payments that you’ll never get back. Revolving credit card balances, payday loan debt and high-interest personal loan debt can all hold you back from reaching your financial goals.

Additionally, tackling bad debt with a more aggressive payoff schedule can help give you breathing room to start your emergency fund. When you make more than the minimum payment on your credit cards, for example, you’ll save money and get out of debt faster.

The table above shows how consumers can save thousands and pay down credit card debt in a fraction of the time by allocating more income toward debt repayment. If bad debt is keeping you from building your savings, you might also consider credit card refinancing or a balance transfer credit card.

You have a short-term need to improve your credit

Many life events and milestones require you to borrow money. If you plan on purchasing a home, buying a car or pursuing higher education, you’ll more than likely have to take out a loan. Consumers with higher credit scores are more likely to receive loan offers with better terms.

One way to quickly improve your credit score is to pay down debt for a more favorable debt-to-income ratio. Paying down debt to increase your credit score may be a higher priority than building your savings, depending on your future financial plans.

When you might (or might not) use your emergency fund to pay off debt

If your emergency fund has gone unused and is growing with interest, you might think it’s needlessly overflowing. In this case, do the math to determine if you have more than you need for three to six months of expenses. Once you’ve reached three to six months’ worth of expenses in your emergency fund, it could be wise to apply extra funds toward your debt obligations, particularly for higher-interest accounts.

But remember that dipping into your emergency fund can always put you at risk of not being able to cover a sudden, unforeseen event like a job loss or hospital trip. Whether you’re willing to bear that risk — and have a plan for the potential fallout, like getting an emergency loan — is up to you.

The bottom line: Using emergency funds to pay off debt isn’t a sustainable strategy. If you’re looking to your socked-away savings to get you out of debt, look for longer-term solutions that will keep your monthly dues more manageable.

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How to start building your emergency fund

Create a budget

The first step to building an emergency fund is budgeting. Creating a budget allows you to analyze your past spending and plan for future expenses. Once you have a better idea of your income and spending habits, you can decide how much room you have in your budget to allocate toward your emergency fund.

How much of your income should you save every month? In general, about 20% of your income should go toward savings, while 50% should go toward “needs” and 30% should go toward “wants.” However, it might make sense to save more or less depending on your circumstances — a senior who wishes to retire soon may contribute more toward savings, while a fresh college graduate may not have as much income to allocate to savings.

Set a goal for your emergency fund size

An emergency fund should cover three to six months’ worth of expenses. Start with a small, achievable goal, and work your way up. Maybe your initial goal is to get your emergency fund to $1,000, or maybe it’s to save one month’s worth of living expenses. Once you’ve reached this realistic milestone, keep going until you’ve built savings that can keep you afloat. This is another step where budgeting comes in handy, since creating one forces you to tally up your monthly expenses.

Where to keep your emergency fund

Because it allows you to grow your savings through interest, a high-yield savings account is the best option for storing your emergency fund. Money stored in a high-yield savings account is also liquid, meaning you can withdraw it as you wish (or in case of emergency).

Look for an account with a high annual percentage yield (APY). This is an indicator of how much money your account will earn in interest. Read the account terms to get a better understanding of how often you can withdraw funds.

How to pay down debt fast with debt consolidation

If you’re wondering whether to build an emergency fund or pay off debt, you might consider debt consolidation, which merges all your debts into one fixed monthly payment with a lower annual percentage rate (APR).

Consolidating debt can potentially help you pay down debt faster, lower your monthly payments and save money on interest. When you save money on your monthly debt repayment, you can allocate more money toward building an emergency fund. Consider the pros and cons of debt consolidation to know if this route makes sense for you.