People often wonder whether they should save up an emergency fund or pay off debt first. It can be hard to know what to do when you’ve got competing priorities, so that’s a common question.
The answer is pretty simple at first glance: everyone absolutely needs an emergency fund, so build a baby emergency fund before focusing on debt reduction. Of course, you’ll want to be sure to continue making the required minimum payments on your debt while doing so.
But there are some other details to consider, like “how much should my emergency fund be?” and other common questions. Let’s start by talking briefly about the different levels of both emergency funds and debts.
What kinds of emergency funds are there?
Emergency funds come in three main flavors: baby, basic, and fully funded emergency funds. The goal is to end up with a fully funded emergency fund, but you’ve got to start somewhere. I recommend starting out with a baby one when you’re paying off debt, because doing otherwise is likely to be both intimidating and costly. Here’s how to build an emergency fund in 6 easy steps.
Baby emergency funds
Baby emergency funds cover a few things that are likely to come up reasonably frequently — such as car repairs, the water heater going out, and medical co-pays. Typically those are $1000 or less.
When you’re first starting out with building an emergency fund, ANY amount you can set aside for emergencies is a good amount. Even $1 at a time is better than nothing. Open a savings account anywhere that doesn’t charge you fees and get started today. Digit is a great place to do so because it saves up for you painlessly and automatically, doesn’t charge you a fee, and doesn’t require a minimum opening balance. As you use your baby emergency fund (and you almost certainly will!) be sure to make replenishing it a priority again.
Basic emergency funds
Basic emergency funds cover everything you would use a baby one for, plus they include 1-3 month’s worth of living expenses — which makes them good for a temporary job loss or a short-term disability. To know the amount you’d need for a basic emergency fund, you need to know how much you’re spending right now on a monthly basis. I highly recommend tracking your spending each day when you’re first starting out anyway, but you can also find this amount by digging through online statements or paperwork. If that sounds overwhelming, aim for 1-3 month’s worth of income plus $1000 instead.
When should you aim for a basic emergency fund vs. just a baby one? That depends on a combination of your comfort level, the sense you have of upcoming life events (is a layoff likely to be in your near future?), and the debts you have. More on that later.
Fully funded emergency funds
Finally, there are “fully funded” emergency funds, which generally cover anywhere from 6 to 18 month’s worth of living expenses, depending on your comfort level. Since it’s such a large amount, most people make this their goal once they are out of debt or close to doing being debt free. I keep my fully funded emergency fund at Capital One 360. (If you use that link, we could each get a small bonus amount too.)
One caution: when coming up with the amount you want to set aside for this, don’t go bare bones on your living expenses thinking you would cut back immediately in case of a major emergency. Chances are you won’t, or your expenses may actually go up during something like that.
Why three types of emergency funds when you’re getting out of debt?
When it comes to debt, some types of debt are harder on your wallet than others, and it’s pretty easy to figure out which is which. Generally speaking, the debts with the highest interest rates and most fees being accumulated are worse than the debts with lower interest rates — especially if you also owe the most money on the worst types of debts. That’s because they cost you the most money and more of your payment goes toward interest.
If you have a bunch of high interest-rate debt and you’re trying to build a fully-funded emergency fund at the same time, you’re not going to make progress very quickly in either area. In that case, you’ll probably want to build just a baby emergency fund at first so that you have something to fall back on (besides credit aka debt) when you need to call the plumber and so that your money will be working hardest for you by knocking out debt faster.
Once you get your debts under control, you’ll have more money available to use in applying that same seriousness to making your emergency fund larger.
However, if you think a job loss is likely or if you’ve got some other huge potential emergency looming on the horizon, there’s nothing quite like cash in the bank to help. In that case, I would definitely focus on building at least a basic emergency fund first while making minimum payments on most or even all debts. (In fact, that’s what I did in the past just before what ended up being four years of unemployment. The money that I was able to save up sure came in handy.)
The rule of thumb for paying off debt vs. saving an emergency fund
Only you can judge what your exact situation calls for, but the rule of thumb for periods of stable employment and good insurance goes like this:
- Save up a baby emergency fund
- Focus heavily on paying off all debt that can be paid off quickly (say, in a year or less)
- Save up a basic emergency fund
- Pay off all non-mortgage debt that takes longer than a year to pay off
- Save up a fully-funded emergency fund
- Pay off mortgage debt
This typically strikes a good balance between minimizing risk and maximizing the money available to pay down debt. Of course, if and when you have an emergency, put the additional focus back on the emergency fund until it’s replenished.
This post is a part of #WMWeek17 – Women’s Money Week 2017 – which is about encouraging financial action, stressing the importance of financial education, and increasing awareness of the financial issues effecting women and families. Readers can get free financial action steps by signing up here.