Which Should You Do First: Establish an Emergency Fund or Pay Off Debt?

Lots of reader comments on my post asking which should be done first -- establish an emergency fund or pay off debt. And, as you might imagine, they didn't agree with each other (or with me). ;-)

First, here's what I suggested as a complete way to handle this issue:

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.

Here's what the first commenter had to say:

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 totaled, 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.

Good point about monthly expenses going down as you pay off debt.

Here's a bit of a different perspective:

I do love Dave Ramsey's method: Build up a $1,000 emergency fund first, then kill off the cards with a vengeance. 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.

Finally, here's a vote from the "save first" crowd:

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.

It's kind of a chicken-and-the-egg sort of question to me. What do you think -- and which do you do/are you working on? Should paying off debt come first or building up an emergency fund?

Comments

[annab]

The emergency fund.

Depending on your circumstance, it can take years to get out of debt, but an emergency can strike in an instant and blow you clean out of orbit. If you're living paycheck to paycheck, and you don't even have that little bit of money saved, it can make it harder to get through the hard times. Not everyone has good credit, or helpful relatives or friends that can be borrowed from in an emergency, but everyone can save a little.

[Phillip]

I like the incremental approach. Get a little in savings to cover you during a small emergency will keep you from adding to your debt. Also, it is not only a practical decision based on math. It has to do with peace-of-mind. Many people would like the security of the 1,000 or so in the bank.

[Julie Ali]

We pay off debt first. We do have an emergency fund but it is actually a debt paydown fund in disguise. We save money in it for 5-6 months; then we put down $10,000 every six months on our mortgage (sometimes it is more and sometimes it is less but we always put down a lump sum payment biannually). The emergency fund goes down to about $1000 when we do our six month paydown and then starts to build up again. A fluctuating savings account of this sort can therefore serve two purposes: first debt pay down and secondly, emergencies.

If you get really creative and save lots, you can also use it to fund other regular recurrent expenses such as property taxes, insurance and special once in a while expenses such as the endless housing projects : the deck, the landscaping and the inevitable repairs.

If we have a real emergency, we take on an extra job. If you have only one debt which is your house, it is easier to manage life's problems with a smaller emergency fund. In addition, if one of the people in a marriage is earning a living wage as opposed to a dying wage (minimum wage) then the other spouse is able to supplement the household income by casual work, weekend work at lower rates of renumeration. Every penny I earn from casual work goes to the mortgage pay down.

Of course, if there is a major illness, diability or accident, all this debt pay down would cease ASAP. But I believe we would still be in a better position with less debt. After all, where would all the money we are using to pay down debt go to otherwise? Consumption? I think not.

[Matt]

I'm strongly inclined to say "pay off debt first". But that may be an artifact of my life situation and experiences.

I have a friend who got a buyout from her employer...she was lucky, and managed to get $80,000 from them to leave 6 months before she would have been laid off with nothing. As it turns out, I was the only person who advised her to use the money, first and foremost, to pay off her outstanding debts. She listened to her other friends instead, and now she's stuck, several years later, with all the money gone, nothing much to show for it, and still having to make debt payments every month...for which she usually has to borrow from friends. And this is not new debt from new consumption, either...this is the same old stuff she could have easily paid off with that severance money, and now be able to actually live on her current income.

Then of course there's my own situation. Once my fiancee and I get married and move into the house, the overwhelming majority of my nonnegotiable living expenses are going to be in the form of debt service (on the mortgage). (Right now it's split evenly between the mortgage and my rent.)

Is there an emergency fund? Sure. But it's sized more according to the assumption that it will get us by until we can refinance (and thus cut our monthly obligations) than according to the assumption that it can support us until we get new jobs at or above our current income level to replace a sudden loss of the ones we have now. I've seen how long that can take, and saving up that much money in cash at this point is unrealistic.