should i save an emergency fund or pay off debt?

Should I Save an Emergency Fund or Pay Off Debt?

Maybe you’ve been gifted some cash or come across a windfall. Or you’ve engineered yourself into the glorious position of making a monthly personal profit (i.e you have savings available – congrats by the way!) and you want to know how to best direct your money. You ask yourself, “should I save an emergency fund or pay off debt?”.

As any modern human, you turn to the internet for answers!

Lets get the basics down

Before we’re too far into this rodeo, I’m going to assume that you have already got your finances to the point that you are making a personal profit each month.

What on earth is a personal profit I hear you scream? Personal profit = income – expenses.

This is the bedrock of a healthy financial situation and ensures your expenses you need to survive are dealt with.

Not there yet? Understand the benefits of budgeting, check out my budgeting guide and help on how to make easy (and hard) savings to try to get you there quickly. Also, the answer is simple for you if you aren’t yet making a personal profit – put this money into an emergency fund. This is because you will need access to this cash until you turn your situation around by cutting expenses and/or growing income to be making a personal profit.

See related: how to save £1000 in a month using my COST method

If you have received an unexpected bill or a financial shock such as losing a source of income, these two articles are for you:

The financial view

If you’re looking at this from a purely financial point of view, you would want to do whatever would bring you the maximum financial benefit.

In this case, you have two options available to you;

  1. Keeping the money in an easy-access savings account as an emergency fund
  2. Paying off some consumer debt

The classic approach to this kind of decision would involve a comparison of the interest rates on both the savings account and the consumer debt you intend to pay off.

The answer would then be pay off the debt if the interest rate is higher than you can get on the savings rate.

If we use some numbers, we can demonstrate the financial benefit based on this choice. So let’s assume that Barry has £2,000 worth of consumer debt on a credit card with an interest rate of 20% and that he can access a savings account with an interest rate of 2%. Let’s assume he has £1,000 which he is trying to decide to save in an emergency fund or pay off debt with.

If he saves in an emergency fund @2% his £1,000 will be worth £1,020 at the end of the year. This is a gain of £20 in a year.

However, if he pays £1,000 off of his credit card debt, he will have saved the equivalent of £200 (£1,000 x 20%) in yearly interest.

In this example, he will be better off by £180 that year if he puts his £1,000 to pay off his debt than putting his £1,000 into his emergency fund.

However, life is never normally that simple and the above ignores the concept of risk in everyday life, so of course there are other forces at play…

See related: can saving money make you rich?

The more rounded answer

If Barry has no emergency fund currently saved up, he is at the mercy of not being able to absorb any external shocks such as unexpected costs or drops in income.

If we play out the scenario where Barry pays £1,000 off of his credit card debt, but then the very next month is hit with an unexpected £1,000 bill, then as he has no emergency fund saved he will have to go straight back to his credit card to fund the unexpected bill.

If for whatever reason he is unable to re-access his credit, or his lenders are unable to extend the credit still, then he has a problem.

There are a few advantages to keeping your money in an emergency fund (whilst you’re building it up) vs paying off your debt:

  1. Liquidity: this is the ease with which you can access the cash. If you have the money in an easy-access savings account, it is easy to get hold of the cash. If you pay off part of your credit card and then your lender reduces your credit limit, you aren’t able to get hold of that if there is an emergency (this is especially important if you have a poor credit score).
  2. Focus: having a cash buffer allows you to stop being reactive with your money, and will keep you on track because any slip-ups due to unexpected expenses will not put you further into debt, they will only erode your emergency fund – this can’t be underestimated psychologically.
  3. Certainty: in periods of uncertainty (like the current COVID19 times), it is generally safer to keep more in cash, because there is a higher likelihood of unexpected costs or drops in income. If Barry had put the £1,000 into paying off his credit card, he can’t access that in cash the next month if he needs to pay a bill.
  4. Not a permanent decision: by putting the £1,000 into an emergency fund, Barry hasn’t made a permanent decision. If he was worried about losing his job and then a couple of months later was more certain his income would be stable, then he could take the £1,000 he saved and pay off some debt with it.

See related: easy and painless ways to save money every month

At what point should I stop saving into an emergency fund and start paying off debt?

Save up the higher of £1,000 or 1 months’ expenses. This is the minimum you should have at any one time. Once you hit this threshold, and assuming you are not in a period of uncertainty, you should start to switch gears and funnel money to paying off your debt.

This will provide enough of a buffer to protect against some external shocks, but allows you to start paying down high-interest debt quickly and keep momentum.

Are you going through a period of uncertainty?

If you are going through a period of uncertainty over your income or if you suspect there to be a higher likelihood of unexpected costs, it makes sense to counter it by putting more money into an emergency fund that is easily accessible. I would suggest the standard 3-6 months’ worth of expenses is a safe target to aim for. I personally maintain an emergency fund on the lower end of 3 months’ worth.

If your situation changes and you believe your income stream is more stable again, you can start to funnel your money into debt repayments. Just try to maintain the minimum emergency fund balance of £1,000 (or 1 months’ expenses if higher).

Unless you are going through a large period of uncertainty and are confident that a 6-month buffer is sufficient, then use any money on top of that to invest for longer-term financial goals such as retirement or children’s education. It is key to understand that simply saving on its own is not the best way to work towards longer-term goals – invest and let the magic of compound interest do its work. Investing also gives your money the best chance of beating that greedy goblin inflation.

How about using a credit card as an emergency fund?

If you have credit available to absorb any unexpected costs (for example if you have available credit on a credit card you could use), then you could fast-track your plans to repay debt if you are not going through a particularly uncertain time.

However, I would still personally push for £1,000 or 1 months’ worth of expenses as a minimum in a cash emergency fund because not everything can be paid for using a credit card. Plus the combination of a small emergency fund and available credit should provide enough of a buffer for even larger shocks.

See related: does PayPal Credit affect credit score?

I hope I answered the question “should I save an emergency fund or pay off debt” – would love to hear your thoughts below in the comments section.

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