To save or to pay down debt?
A common question in the world of personal finance is whether you should focus on saving for an emergency fund or on paying off your credit-card debt first.
Put another way: should you prioritise using your finances to pay off your debt, thereby reducing the interest charged but risking not having funds available for emergencies and potentially needing to use the credit card you were paying down?
Or should you focus on saving three to six months’ worth of expenses in an emergency fund, continue making credit-card payments while incurring interest, but have the peace of mind that you can cover emergencies without taking on additional debt?
It’s a good question, reminiscent of the classic dilemma, “Which comes first, the chicken or the egg?”
Consider this: an emergency fund offers the resources to cover unexpected expenses without incurring debt or paying credit-card interest. In contrast, without an emergency fund, if you have existing credit-card debt that is accruing interest, you’re in a challenging position when deciding where to focus your financial efforts.
Before making a decision, it's crucial to understand what each financial strategy involves.
An emergency fund is a savings buffer set aside for unforeseen expenses such as household emergencies, car repairs or unexpected job loss. With an emergency fund, you can steer clear of high-interest debt, avoiding reliance on credit cards or loans in times of need.
In addition, an emergency fund bolsters financial resilience by allowing you to manage job loss or income disruptions without resorting to drastic measures. It also strengthens overall financial health by enabling investment opportunities without the fear of financial ruin from minor setbacks.
The golden rule is, ideally, to save enough to cover three to six months’ worth of living expenses to prevent accumulating further debt during financially challenging times, thus empowering you to make informed financial decisions whilst maintaining your quality of life in the face of such challenges.
Conversely, credit-card debt typically carries high interest rates, with averages ranging from 18 to 22 per cent. Late payments can potentially increase this rate even further.
Paying off this debt not only reduces the burden of monthly payments but also eases the stress caused by accumulating interest on ever-increasing balances that seem overwhelming.
It also encourages you to live within your means and develop financial discipline. Remember that being debt-free should offer a sense of accomplishment and security, which will pave the way for a more stable financial future and peace of mind.
The case for building an emergency fund first
• Financial safety net: An emergency fund serves as a financial cushion, protecting you from further debt when unexpected expenses arise and you lack the means to pay them upfront. Situations like sudden household bills or car repairs can worsen your financial situation if you rely on credit cards to cover these costs.
• Peace of mind: having funds reserved for emergencies provides peace of mind, allowing you to face life with less anxiety over financial crises. When emergencies occur, an emergency fund acts as a buffer, thus preventing panic-driven financial decisions.
• Avoiding additional debt: without an emergency fund, any unforeseen financial burden may force you to rely on credit cards. This can lead to a vicious cycle where you pay off one debt only to accumulate another, often with higher interest rates, due to a lack of savings.
The case for paying off credit-card debt first
• Interest costs: prioritising debt repayment is crucial due to high interest rates. Credit-card debt can grow rapidly, causing the balance owed to increase faster than you can accumulate savings. Over time, targeting high-interest debt can often be more financially advantageous.
• Psychological relief: for many, the burden of debt can lead to stress and anxiety. Eliminating debt can improve emotional wellbeing, offering relief and peace of mind, both mentally and financially.
There are benefits to both building an emergency fund and paying off credit card debt. But there are also down sides to putting one before the other. Therefore, finding a middle ground is likely to be most advantageous.
Middle ground
A hybrid approach may effectively balance both priorities. With a little jigging here and there and by making a couple of short-term sacrifices, you should be able to accomplish both goals. The question is where do you start?
1, Build a small emergency fund
If you currently lack savings, aim to set aside a modest amount, such as $500 to $1,000. This initial emergency fund can buffer against immediate financial surprises while enabling you to reduce your credit-card debt gradually.
2, Prioritise high-interest debt
When managing multiple credit cards, focus on paying off the one with the highest interest rate first. This is known as the avalanche method. It will save you money over time, whilst still allowing you to maintain a small emergency fund.
3, Consider the snowball method for motivation
If you find achieving small successes provides encouragement, prioritise paying off smaller debts first using the snowball method. This can boost your motivation, thus enhancing your financial habits and enabling you to reallocate payments towards both debt reduction and savings over time.
4, Develop a budget
Creating a budget that allocates funds for both debt repayment and savings can promote financial discipline. A well-structured plan helps you visualise your financial progress and stay committed to achieving your goals.
Ultimately, deciding between saving for an emergency fund and paying off credit-card debt is a complex and personal decision. Both goals are essential, and to find a balanced approach, it's crucial to consider your unique circumstances, financial habits, and long-term objectives.
By evaluating your current financial situation and implementing a strategic plan, you can move towards financial stability and peace of mind. Whether you prioritise saving, debt repayment or a blend of both, the key is to take action that aligns with your overall financial goals.
• Carla Seely has 25 years of experience in international financial services, wealth management and insurance. Over the course of her career, she has obtained several investment licences through the Canadian Securities Institute. She holds the ACSI certification through the Chartered Institute for Securities and Investments (UK), the QAFP designation through FP Canada and the AINS designation through The Institutes. She also has a Master’s Degree in business and management