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Work on Debt Reduction or Build Savings?
There is huge amount of personal finance tips on the web, in books, on the radio, and on the television. The problem for most people is what to do first. Should we start by investing? Should we pay off our credit cards? Should we have 6 months of savings in the bank before we do anything else?
The answer can be difficult because each one of us have different financial circumstances. Some are single, some are married, some have kids, some don’t. Some work full time and go part time to school, some are the reverse, and some are fresh out of college looking for answers.
Today we’re going to look at two goals that most people have first:
- Build an emergency fund of 3 months
- Pay off all credit card debt
They’re both great goals to have and are necessary if you want to get ahead.
Which Makes Financial Sense?
Let’s run a scenario and see if a decision comes out of it. Say you have $1000(tax refund, scholarship, etc) and you also have $1000 credit card debt. You can put th money into a savings account and earn 4% a year or you pay off your $1000 debt which is on a card with 23.99% interest.
Here’s how your net worth would change if you decided to put it into savings:
| Initial | 1 Year | 3 Years | 5 Years | |
|---|---|---|---|---|
| Savings Account | $1,000.00 | $1,040.00 | $1,124.86 | $1,216.65 |
| Credit Card Debt | ($1,000.00) | ($1,239.90) | ($1,906.16) | ($2,930.44) |
| Net Worth | $0.00 | ($199.90) | ($781.30) | ($1,713.79) |
How Life Affects Savings and Debt Reduction
If life were purely financial, then paying off the debt immediately would be the way to go. You come out better. The problem is bad stuff happens. If you’re pouring every last spare penny into paying down your debt with no savings whatsoever, then you’re leaving yourself vulnerable. If something like your car dies, then you could end up dipping back into your credit card to bail you out.
Bad events keep you in this cycle. How do you solve this? Create a bare bones emergency fund. For how much? That depends on your circumstances.
Basically think a possible misfortune that could set your debt repayment back and use that as your bare bones goal. Some pick an arbitrary number like $1000 or something like one month’s expenses.
From there, pay your debts down while saving a small percentage into your savings. You’ll build your cushion up, but still pay your debts faster.
Why Should You Do?
Personal finance is not a one size fits all, so please let me you how you’ve tackled the problem or what you’re doing now.
Photo Credit: Pikaluk
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I talked about this a bit in my piece When not to put money in your 401(k), where I suggested that accelerated debt payments come after getting the full corporate match on your 401(k), but before doing any other saving or investing.
I think you’re right, though, that you want to have at least a bare-bones emergency fund even before that. A corporate match is a huge chunk of money, but the costs of a major glitch in your finances without an emergency fund to smooth it over, can be even larger.
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I’m in the middle of this conundrum myself. My latest decision was to turn my gun savings into emergency savings, put 10% into it, not bother with any other savings until it’s up to $1000, and still work as hard as I’ve been to tackle my debt.
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I actually did everything backwards. I had about 9 months of savings in my emergency account, then I looked at my interest payments on debt and thought, gee, this is stupid. So I took over half of that money and immediately put it toward debt payment.
And here is the most important part: I made a PLAN to eliminate the remaining debt. I had not been making much progress until that point, even though I was making well above the minimum payments. So I set up an Excel spreadsheet to track my payments and balances, started using Quicken for my bank accounts, and gave myself a $100 weekly allowance for groceries, gas, and misc. items. I also set aside some of my “bonus money” (from overtime pay, expense checks, rebate checks, gifts) to cover irregular expenses like vet bills or insurance payments. Everything else goes into savings and debt repayment.
I transferred most of my remaining debt to a 0% for 12 months credit card and am making minimum payments while putting the extra debt repayments in my high-yield savings account to earn interest. Then I will pay off the card before the offer expires.
I have another goal I am saving towards in the meantime that I want to be able to pay in cash. So I am saving gradually for that while I am repaying my remaining debt. If I can stick to this plan (and I have done so for 9 months now with no problems), I should be completely debt free in another 16 months. If I have additional bonus money, it will be sooner than that!
I really appreciate everyones comments. Shela, I’m happy you have a plan of attack and that your have already paid down soem debt. Please come back and let everyone know of your progress!
build up emergency fund first. once u have 3 months saved up, start paying off your highest interest-rate debt first.
I’m with the bare bones approach. My debt is costing me way too much now to build an emergency fund. I am direct a small percentage into an emergency fund with a goal of $1000 but I will channel most money toward high interest debt until its paid off. At that point I will gladly build a nice soft cushion of 3-6 months
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Great post. I agree wholeheartedly that one size does not fit all when it comes to a personal financial plan.
It is very important to have a cash emergency fund of some reasonable sum before using all extra money to attack debt. There are different schools of thought on the best way to pay off the debt, but attacking it in any fashion as long as you stick to a plan will work. But you have to have that cash back up to keep from using debt when life happens.
Personally, I think the price of a transmission in my car is what the balance of my emergency fund should be, or a little more. The little more would be like the cost of an emergency room visit for an emergency that won’t require a hospital stay, but does require immediate treatment, like a broken bone or laceration.
I pick those because a transmission is one of the most expensive repairs or replacements that can happen to a car. If you don’t have enough cash to pay for it, you have to go into debt because you usually need your car to get to work. A medical emergency that requires ER care only will run anywhere from $500 – $1500. If you don’t have insurance or you have a high deductible, you need cash.
Sherri
Check out Debt Free or Bust – Sherris last blog post..Sponsorship Opportunity on Debt Free or Bust!
@ Sherri: That’s a wonderful idea on calculating how big to build your emergency fund. We had to have transmission work with my husband’s car and it was $650! It was a big chunk of change, but like you said, if a car needs it, it has to be paid.
[...] week, the idea or deciding to pay off debt or save for a full emergency fund came up. It seemed that having a barebones emergency fund to keep you [...]
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