Pay Debt versus Establish an Emergency Fund versus Saving -- Which to do First?; Free Money Finance Guide to Saving, Investing, and Paying Off Debt

There's an on-going debate around what you should do if you're in debt: pay off your debt first or establish an emergency fund, then pay off the debt. My basic philosophy was detailed in Comments: Over One-Quarter of the Population on the Brink of Financial Disaster, Need Discipline where I stated:

I recommend paying off the debt first because: 1. it's costing you money (a lot) that's digging you deeper into debt and 2. if you pay it off, it's not like that money's gone. You can charge again if you HAVE to (if you get into trouble financially) This has the same effect as saving money for future expenses. However, if you save first, you're paying interest on the debt the entire time you're saving. Doesn't seem like a smart move to me.

To add a few more specifics to this, here's what I'd recommend as the order:

1. Pay off high-interest, credit card debt.

2. Establish an emergency fund.

3. Pay off other debt.

To add to the debate, here's a piece from USA Today that throws another element into the mix -- saving (in particular, for retirement). They give some thoughts on paying off debt versus establishing an emergency fund versus saving for retirement. But first, they tackle the debt versus emergency fund issue. Their thoughts:

The return on paying off debt is roughly equal to the interest rate you pay. Many credit cards charge 18% or more: You'd be hard-pressed to find another investment earning 18%. "It's like giving yourself a risk-free 18% return," says Don Lutomski, a financial planner in Birmingham, Ala.

Consider a couple with $10,000 in credit card debt. They paid 18% interest. The credit card company requires them to pay at least 4% of their balance each month, or $35, whichever is larger. If they paid just the minimum, they'd be paying for more than 10 years. Total interest: $5,575.

But if they paid $100 more than the minimum each month, the couple would end up repaying the entire balance in 50 months, a bit more than four years, saving $2,285 in interest. Best of all, they would have wiped out their debt, boosting their cash flow by $265 a month.

By contrast, the returns from a savings account seem paltry. Had you stashed your $100 a month into a bank savings account paying 5% for 50 months, you'd have about $5,424 in your account at the end of the period. You would have earned just $425 in interest.

This is the same rationale that I use when recommending that people pay off credit cards first. Financially, it's just the better option of the two.

But USA Today isn't making this a firm recommendation. They hedge their bets a bit here, noting later in the article that emergency savings are important too (which I agree with), especially when you lose your job. As such, here's their recommendation:

Your best strategy: Build up your savings at the same time that you pay down debt.

Now that's useful advice, huh? Why not just state the obvious?

It doesn't seem very practical to me to do both -- besides, it really results in no recommendation at all. I'd love to say "do it all" in all of my recommendations, but that's not very helpful in my opinion.

The rest of the article hems and haws and really doesn't make a complete recommendation, so I'll make one:

1. Spend less than you earn. This alone is THE key to getting rich. Said another way, save a portion of all you make.

To spend less than you earn, you may need to earn more or spend less.

2. Contribute to your 401k to get the full employer match.

3. Pay off your credit card debt.

4. Establish an emergency fund.

5. Pay off all other debt.

6. Invest your savings regularly in good, solid investments. I like index funds.

7. Do this for a long time, letting the power of time and compounding work for you.

Comments

[Dale G.]

Although you shouldn't sacrifice building up your emergency fund, there is an additional factor to consider. As you pay off debts, your monthly minimum expenses go down. One of the most important measures of your emergency fund is how long you can live off of it. Emergencies can change that. If your car is totalled, you may find yourself buying another car before you expected to. I went through that two years ago.

The choice isn't clear-cut. Money used to pay off debt isn't available in savings. However, money in savings goes farther when you have fewer debts to cover.

[Financial Reflections]

I do love Dave Ramsey's method: Build up a $1,000 emergency fund first, then kill off the cards with a vengance. After that, finish building an emergency fund.

It keeps people from going back to the one thing that got them in trouble - small charges to credit card. Granted a big problem may happen, but most of the issues people have are $1000 or less, such as getting the car fixed or calling a plumber.

I also like Dale G's point. Once those cards are paid off, your emergency fund will last that much longer. I calculate my minimum burn rate every month to get an idea of how much money I'll need to live on.

[annab]

I think another thing to is that if you don't have a credit card (but say you have other debt) then having the money in savings is very helpful.

[raising4boys.com]

Boy, you're treading on thin ice when you question the words of The Dave.

[Mike Kaply]

Step one in getting out of debt is deciding not to get in any more debt. By paying off debt without any emergency fund, the first emergency that comes along, you are going to add to the debt.

Get a small emergency fund to cushion you from life. Then payoff the debt.

I've been there, and knowing that we had 1000 dollars just in case made a huge difference - and the emergencies did come. And we did not get in more debt.

[Donna]

This is the best advice I ever got -- my father-in-law, an old timer, who would rather save for something than buy on credit -- told us years ago that paying off debt is the best investment you can make -- it is the only guaranteed rate of return on your money; whatever the interest is. Of course, had we taken his better advice and never bought on credit to begin with, we might not be worrying about whether to save or pay off debt right now. But, coulda shoulda woulda (as my husband says). Retirement is another matter altogether. The money in there needs some time to grow and you get the tax benefits. Thus, the cost-benefit analysis is less straightforward than saving for "emergencies" or paying off debt. We are going by the pay off the debt first, save for emergencies second (before we pay off the big debts), and, all along, save for retirement.

[David in Hutto, TX]

I got way over my head in credit card debt back in 2003 after losing my job and being out of work for 2 years. I was living off credit cards all the while thinking I would be able to pay it back with a new job. That never happened so I filed bankruptcy and wiped out the debt. To prevent this from happening again, I started using my debit card whenever I had the need to use credit. This worked great for a few years and kept me debt free until January 2006 when I found an unauthorized charge to AIR FRANCE for over $800. YIKES! I had become a victim of identity theft. It took a week to get the money back and a bunch of paperwork but all in all I learned a lesson from that. Now, all of my expenses that used to be auto-debted from my checking account are now charged to a credit card. This protects me from more fraud but I could easily slip back into those bad habits that got me in trouble before. It helps that I have had steady employment since December 2006. Call me paranoid but I check all of my credit cards and bank account balances daily just to make sure I don't become a victim again.

[Kathy Lugo]

I just read your article on tithings and paying off your debt and let me just say it brought me to tears. I have been so disobedient to the Lord and I am having a hard time stepping out in faith. I just started tithing about a year now and I think I missed a couple of times(lost count) so you cna say not a faithful tither. Anyways my husband and I work I am a believer and he just now starting to become a believer so I have been the only one tithing. I have asked my husband in the past to tithes but he really doesn't really give me an answer. So how do I approach him about this and how do I get to really step out in faith and cheerful pay my tithe and give so that i can be debt free. I know I know in my heart that God can do it but why to I second guess myself and cry so much about this?

[FMF]

Kathy --

Don't fret. God knows your heart and knows you want to tithe even if your husband is unwilling to do so. I think He'll bless this attitude, so you should not despair during the time you're working up to both of you being able to tithe.

[James Young]

Great advice!