Credit Card Debt vs Emergency Savings – Which Comes First?
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Choosing whether you should pay off credit card debt or save for an emergency is a crucial decision, but it is possible to do both. Credit cardholders have seen their debt amount grow since the beginning of the pandemic. According to Experian’s annual credit survey from 2021, Americans’ average debt as of 2021 is $96,371 and the number has only increased over the year. This is when the dilemma of whether to save money or pay debt arises. Debt management is a skill you must learn and then decide whether you want to build a safety net first or go debt free first.
Your emergency fund is like an umbrella for unexpected expenses that can help avoid high-interest debt during a difficult situation. However, building one isn’t easy if you already have debt.
One of the most important things is to take a good look at your financial situation and immediately put the right habits in place. This will help you choose the right path.
When deciding whether to pay off debt or put money in an emergency fund, you must look at the interest rate on the debt and allocate the cash accordingly. When the interest rate is low, it is possible to split 50/50 between emergency savings and debt payoff. However, if the interest rate is high, you should pay debt first and put a small amount in savings. In this case, you will have less emergency savings to pay off debt faster.
Once the habit is in place, you can shift how much money you put in each direction.
You must also do what makes you feel successful on the journey towards becoming debt-free. Here are a few strategies to help you tackle the financial situation better.
In this article
When to make the emergency fund a priority
You do not have any savings
Everyone needs to have at least a small emergency fund, but if you do not have any savings, you can start saving some money immediately. An emergency fund will help you avoid taking a loan whenever you need money for an urgent expense. The fund will also keep you going in difficult periods of distress, like illness or unemployment. If you are not bringing any income, you will always have a safety net to pay for the monthly expenses like rent. So, if you do not have an emergency fund, make it a priority to save a specific amount each month and put it aside.
You must have at least three months of funds in your savings account. This is the money you will not need immediately. You can start by saving enough to help cover an unplanned expense like a medical bill or home repair. Once you have this, you can start paying down debt.
After you have an emergency fund, you need to leave it untouched and only use it for emergencies. Do not use the emergency fund for something that might not be an emergency. The goal is to spend some money regularly, no matter the amount. You can start with $100, as long as you remain consistent, and in a year or two, it could grow into a substantial amount of money.
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You have debt that does not drain the finances
If you have good debt which does not affect your finances, you might want to prioritize building an emergency fund. Good debt includes student loans, mortgage debt, credit card debt, and short-term to medium-term auto loans. You can make the minimum payments on the debt but keep the extra money in the emergency fund.
How much should you put in the emergency fund?
It is recommended to have at least three to six months of living expenses in the emergency fund. How much you will need will also depend on whether you are using the funds for something small like a car repair or something huge like a medical bill. If you think you need to set aside more, it doesn’t hurt to do so. Consider an adjusted budget to reduce spending to only basic living expenses for long-term financial emergencies.
Related: How to Start an Emergency Fund
Strategies to build an emergency fund faster
Set a budget
If you want to build an emergency fund, you need to create a budget first. It will allow you to analyze and understand your spending pattern and then plan for future expenses. With a clear idea of the monthly income and spending habits, it will be possible to decide what you can allocate towards the emergency fund.
Identify the percentage you need to save each month
You must try to save 20% of the income and put it into the emergency fund. Experts recommend following the 50/30/20 rule for budgeting, where 50% of the income should be spent on needs, 30% must go towards the wants, and the remaining 20% should be saved. You can always save less or more based on the circumstances.
Create a goal for the emergency fund
An emergency fund should be able to cover 4-6 months’ worth of expenses. An ideal start is to pick small, achievable goals and move upwards. The initial goal could be $2,000 or simply to save a month’s worth of expenses. After achieving it, keep going till you have built enough savings that you might not need to apply for loans in case of emergencies. This is also where budgeting will come in handy.
You can consider keeping the emergency fund in a high-yield savings account. It will build your retirement savings while allowing you to withdraw from the account without any fees. This means quick and easy access to money whenever the need arises.
When to make debt payment a priority
There is a huge obligation for repayment
When you have a mortgage, or an auto loan over your head, make it a priority to repay it. Never skip the minimum monthly payments if you want to grow the emergency funds. When you skip the debt payments, it will lead to a late charge or a dip in the credit score, or the lender might send the debt to collections. Consider all the loans and living expenses whenever you build your budget. If anything is falling outside of needs, use it to repay the debt.
It is difficult to manage the high-interest debt
It should be your priority to pay down the high-interest debt if it negatively affects your income. When you have bad debt, it will siphon money from the monthly budget in the form of interest payments which you will not get back. Whether it is a payday loan debt, a personal loan, or a revolving credit card balance, it can hold you back from your goals. When you aggressively tackle the bad debt, you save money on the interest and get rid of the debt faster so you can build the emergency fund at the earliest.
When you need to improve your credit score
A lot of life events will require you to apply for a loan; this is when your credit score will matter. Whether you want to buy a home or a car, you will need to take a loan. If you have a high credit score, you will receive the loan on better terms, including a low APR. But if your credit score is low, you should work on it before you apply for a loan. This is when debt payoff should be your priority.
Related: How Credit Score Ranges Impact Your Ability to Borrow
You do not want to take new debt
If you have to plan for a large purchase, you must budget well, and using cash is an ideal way to avoid unnecessary debt. Save money for big purchases instead of paying more toward the debt and then applying for a loan again. It will be advisable to pay the high-interest credit card debt first and then save for the holiday or home renovations.
Before you save money to pay the debt, consider the loan terms. It makes no sense to pay down a low-cost debt only to take on new, more expensive debt. Hence, remember to save and pay for an expense to avoid another loan.
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Strategies to tackle credit card debt faster
Watch your spending habits
Debt repayment starts with looking at how the debt came around in the first place. If you do not figure out how and why you got there and how to stop the debt from growing, you will end up again. A lot of people have a tendency that impedes their efforts like buying things they do not need or using their credit card for every single unnecessary purchase they make. This could lead to a debt mountain. The first step is to watch your spending habits and try to cut down on unnecessary expenses.
Snowball vs. avalanche
If you can cover the minimum debt amount, you have some choices. Handle the smallest debt first and then roll the cash toward the next lowest debt, this is known as a snowball method. Alternatively, you could first pay off the debt with the highest-interest rate and then work on the other debts, this method is known as the avalanche method.
It will cost you the least if you decide to prioritize the debt with a high-interest rate, but you will have to stick to a plan. If you are someone who has always struggled to pay off debt, getting a high-interest debt paid off first will be really satisfying and will keep you on the right track.
Automate the payments
You can also reach your goals by setting up automatic payments. Once you set up the payment, you will forget about it, and before you know it, you would have made major progress on your goals. It will also help avoid the late fees, and you can reward yourself once you’ve paid off the debt or received a little extra income like a bonus at work.
Can you build savings while paying off debt?
It is possible to set up both lines to start the process. A lot of people tend to put off saving while they are paying off debt, and life goes on, but they never get a chance to build an emergency fund. Once you have secured the baseline, you should steer money towards the credit card debt payoff. Automating the debt payments can help avoid late fees and become debt free sooner than expected.
You must also remember that the interest rate on the debt will be higher than the interest you will earn on the savings account. Hence, you will pay more interest on the debt than you earn on your savings.
You might also want to consider a balance transfer card to pay less interest on the credit card and have more cash for an emergency. The card will allow you to consolidate the high-interest debt into a single new card with 0% interest for 12 months or more, depending on the card. Be careful when you open and use a balance transfer card. If you cannot pay down the balance before the expiry of the promotional interest rate, you could end up in another debt cycle.
Related: Best First Credit Card – No Credit Is No Problem
Can you use the emergency fund to pay off debt?
If there is a situation where the savings fund has gone unused, and your debt is growing due to accruing interest, it could be wise to use the emergency fund to pay off the credit card debt. Do the math, decide if you have more than your requirement of three to six months of expenses, and apply the extra fund toward the debt obligations. Start with the high-interest accounts first.
Another alternative is to invest the extra emergency funds where you could earn more due to compound interest. If there is a chance to earn more interest through investment than the interest you would have to pay out on the debt, you should prioritize investing over debt repayment.
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The bottom line
Building an emergency fund has several advantages, but it should not be at the cost of high debt. If you are drowning in debt, your only priority should be repayment to avoid penalties and late fees. But if you are in a position where you can handle the debt over time, consider putting aside a little money each month in the emergency fund.
It is not sustainable to use emergency funds to pay off debt. When considering savings to get out of debt, you must look for longer-term solutions to help manage the monthly dues. You must always identify the type of debt and your financial goals before you decide to save or pay it off. Regardless of your financial situation, you should never underestimate the importance of an emergency fund.
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Editor
Vandita Jadeja is a financial writer and editor at Joywallet. She loves to read and write about money and brings a decade of experience from the financial industry.
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