Should You Build an Emergency Fund or Pay Off Debt?

Date posted: Oct. 21, 2016
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Photo Credit: Daren

 

Paying off debt is where most Canadians start their journey to financial prosperity, and it’s easy to see why. Paying off your debt means you’ll no longer be in a cycle of charging purchases to your credit card without having the money to pay for it. Paying off your debt will improve your credit score and help you access the best lending rates for a mortgage or line of credit. Finally, paying off your debt frees up money, which you can then use for your real priorities, like investing for retirement or saving for a home.

So what are you waiting for? It’s time to start paying off your debt!

Well, it's almost time to start paying off your debt. Before you dive into debt repayment, you need to consider how you are going to pay for any unexpected expenses that come up along the way. What if your car breaks down and needs several thousand dollars in repairs? What if your pet gets sick and you need to take it to the vet? How will you pay for life when you are paying off your debt?

If you think you’ll handle these unexpected costs by charging them to your credit card, I urge you to rethink that strategy.

Consider this scenario: you are trying with all of your might to pay off your credit card debt, and then an unexpected expense sets you back several thousand dollars. You may get discouraged and give up!

Instead, most personal finance experts recommend you save a cushion of cash before you start paying off your debt. This cash cushion is usually called an emergency fund.

But just how big should this emergency fund be?

A full sized emergency fund should be between three and six months of essential living expenses. You should keep this money in cash in a savings account where it is readily available in the event of an emergency.

The problem is, an emergency fund of this size will take you a long time to build up, especially if you are also making minimum payments on your debt.

So should you pay off your debt or save for an emergency first?

Personally, I don’t think you should build a fully fledged emergency fund before paying off your debt, for a few reasons:

First, saving three to six months of living expenses is a lot of money. It could be up to $10,000, which could take you months or years to save.

Second, since you are saving this money in a savings account, you won’t be earning a very high-interest rate. In contrast, your high-interest debt could be costing you hundreds of dollars per month. Having money sit in a savings account earning almost no interest while your high-interest debt racks up interest charges is not the best allocation of your resources.

I don’t think that building up a full emergency fund is a good idea, but you also shouldn’t go full tilt into paying off your debt without a plan to handle unexpected expenses.

Instead, I advocate a hybrid approach.

Before you begin your debt repayment journey, you should build up a “baby” emergency fund. A small cash cushion of between $2,000 and $3,000 will help you handle most minor emergencies without affecting your debt repayment plan.

There are several other pros to saving a baby emergency fund: You aren’t tying up as much money in a low-interest savings account. It won’t take as long to save, which means you’ll be able to tackle your debt sooner, and it will give you a sense of how real financial stability feels.

A baby emergency fund is a good compromise between saving money and paying off debt and will set you up for success in your debt repayment journey.

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