Deciding whether to pay off debt or save for an emergency is an important choice to make, but you may be able to do both.
Since the start of the pandemic in March 2020, 42% of credit card holders who already had debt saw the amount increase, according to a September 2021 Bankrate survey of 2,400 American adults. Meanwhile, only 4 in 10 Americans have enough savings to cover an unexpected $1,000 expense, according to a separate Bankrate January survey. Bankrate, like NextAdvisor, is owned by Red Ventures.
The most important thing is to take an honest look at your financial situation and implement helpful habits right away, according to two experts we spoke to. Here’s what to keep in mind when developing your own plan.
What to consider when deciding
You want to look at the interest rate on your debt and allocate your money accordingly, says Certified Financial Planner and Financial Psychologist Brad Klontz. If your rate is low, you can split 50/50 between debt repayment and emergency savings, and if it’s high, you can do 90/10 with a debt focus. “When the habit is in place, then you can move the amount of money you put in in each direction, but you’ve got all the pipelines in place,” Klontz says.
At the same time, you want to do what makes you feel successful on your debt repayment journey, says Summer Red, AFC®, education manager at the Association for Financial Counseling and Planning Education. “I would probably have less emergency savings so I could pay off that debt faster,” she says.
When should you first set up an emergency fund
Ideally, you would have at least a basic emergency fund, but if you don’t have any emergency savings, it’s a good idea to save some money right away. Although experts generally recommend at least three months, you don’t necessarily need it right away. Start by saving enough money to cover an unexpected expense like a car or home repair, or a big medical bill. “So it might be time to address debt repayment,” Red says.
Once you have saved money for emergencies, be careful not to touch it and only for emergencies. “If you don’t maintain your car, if it breaks down every couple of months, you may be using your emergency fund for something that may not strictly speaking be an emergency,” says Red. . Instead, you can add up recurring expenses, such as birthdays or oil changes, divide by 12, and save that amount each month, she says.
The goal is to start putting money aside on a regular basis, no matter how small. “For some people, $100 isn’t much. In a year or two, that’s a lot of money,” Klontz says.
Can you build savings and pay off debt at the same time?
Configuring both pipelines helps start the process. “I’m a big proponent of doing everything now, without waiting,” Klontz says, adding that too many people put off saving while they pay off debt. “Because life goes on and you didn’t create this account.”
Automating your debt and savings payments can help you avoid late fees and grow your emergency fund.
Once you’ve secured your baseline, you can direct more money toward debt repayment. Interest rates are another thing to keep in mind, Red says. The interest rate on your debt is likely much higher than the interest you’ll earn on a savings account. In other words, you’ll likely pay more in interest owed on your debt than you’ll earn in interest on your savings, Red says.
You can also consider a balance transfer card to help you pay less interest on your credit cards and leave you with more money for emergencies. A balance transfer card will allow you to consolidate higher interest rate debt onto a single new card that has a 0% interest rate on the transferred balance for 12 months or more, depending on the card.
Before you open and use a balance transfer card, make sure you have a plan in place to pay off the balance before the promotional interest rate expires. Otherwise, you could find yourself in another cycle of debt when the higher normal interest rate kicks in.
How much should be in your emergency fund?
Experts generally suggest that you have three to six months of living expenses in your emergency fund. “It was pretty consistently three months before 2008, and then we had a devastating blow to the economy, and that’s when it stretched,” Red says.
Of course, the amount you’ll need depends on whether it’s to be used for something smaller like a basic car repair, or something more traumatic like a job loss. “If you’re in a field where there are only a certain number of positions or you’re extremely well paid, it may be difficult to replace that income, and you may want a little more padding there- down,” Red says.
For longer-term financial emergency scenarios, consider an adjusted budget that reduces your expenses to only essential living expenses. To find an emergency fund that works in this scenario, you can cut back on expenses like streaming subscriptions, clothing, or other discretionary expenses until you’re on more solid footing.
You’ll also want to consider your levels of anxiety and security, and whether they’re affecting your quality of life. “How important is it to you to have an emergency fund, emotionally?” said Klontz.
Ways to Tackle Debt Faster
Look at your spending habits
Paying down debt starts with looking at how the debt arose so you don’t just put a band-aid on the problem, Klontz says. “What is the state of mind? What were the events? How did you get there?” he said. “If you don’t know how you got there, and how to stop the bleeding and how to cure anything, you’re going to end up there.”
This is especially true given that many people have a tendency that gets in the way of their efforts, such as buying things on sale that they don’t really need, Red says. “‘See that, it’s 8% off?’ And it’s like, ‘OK, this dress is lovely, but you have four closets full of dresses with the tags still on them. Have you tried paying off your credit cards?’” she said.
Snowball vs avalanche methods
Being able to cover your minimum debt is key to avoiding fees, and after that, you have choices. Tackle the smallest debt first, then shift your money to the next lowest debt is called the snowball method, and pay off the debt with the highest interest rate first. calls the avalanche method.
Although prioritizing the debt with the highest interest rate will cost you the least, it’s what encourages you to stick to a plan. “If you’re someone who’s driven by the idea of saving every penny possible, choose the interest rate first,” says Red. “If you’re someone who’s been struggling to pay off debt for a long time, maybe just paying off one will be really satisfying and help keep you going.”
Automate your payments and savings
Setting up automatic payments can also help you achieve your goals. “That’s where the magic happens because you’re going to forget about it,” says Klontz, who says people tend to keep things the way they are. “You’ll revert to your status quo bias, and before you know it, you’ve made major progress on those goals.”
Canceling an automated gym membership, for example, is tough because you have to admit you’re not prioritizing your health, Klontz says. But when you’re automating something that works for you, the status quo bias helps. “If you’ve set up an emergency fund or a college savings fund, the mental energy you need to do is go in and say, ‘I’m going to steal my kid’s college fund,'” says- “Imagine the goal. When there’s no goal, the money disappears,” says Klontz.
Automating your debt payments also helps you avoid late fees, and you can reward yourself after paying off debt or receiving additional income like a tax refund or bonus at work. “Use some of it for something fun, but then use the rest for financial goals,” says Red.