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Every family needs an emergency fund. The recommended balance of the fund is between three and nine months of living expenses. The fund will give you the resources you need to cover unplanned expenses such as car and home repairs, medical costs and worst of all, unemployment.
According to a recent study by the Federal Reserve on the economic well-being of U.S. households, 40% of adults faced with an unexpected expense of $400 said they would not be able to cover it or could only cover it by selling something or borrowing money. More than 20% of adults said they are not able to pay all of their current month’s bills in full.
This can be the cause of another problem many Americans have: high credit card balances. While the same Federal Reserve survey said half of all Americans said they had set aside emergency savings equal to three months of living expenses, 70% of adults said they could tap into savings or borrow in the event of a financial setback. It is the latter alternative that gets many people into trouble.
The primary reason why people should have an emergency fund is to help them break that cycle of debt. It gives them the savings they need to pay for a car repair or similar emergency without having to use a credit card.
Balancing saving for emergencies and repaying debt
If you don’t already have an emergency fund, you should start saving for one today. But what about if you also have high credit card debt? How should you allocate your cash between debt repayment and “saving for a rainy day?”
If you search this question online, you will get a variety of answers. Some say to pay off your debt aggressively first and save later. Others say set aside at least some money — $1,000 or more — before you begin aggressive debt repayment.
Tyler V. Cook, certified financial planner and managing partner of John E. Sestina and Company in Columbus, Ohio is one of those who believe that people need to save at least some money before they begin to aggressively pay off high credit card debt.
But starting a small savings fund, Cook said, is fine. He suggests having an automated transfer made every month to a separate emergency savings account. Then, split any additional cash that comes in between your emergency fund and paying off high credit card balances.
Setting up an appropriate emergency fund may not happen overnight. But even splitting your money between savings and debt repayment could make a difference, as some consumers without savings have to turn to credit cards in a financial emergency.
“Using a credit card to pay for an emergency,” Cook said, “is the worst possible scenario.” Credit card balances can quickly rise with high interest rates, making it harder to dig yourself out of debt.
However, you may feel as though repaying your debt is more important than putting any cash toward an emergency. Here’s what to consider if you’re still unsure about how to allocate your free cash.
When paying debt is more important than saving
There are circumstances where repaying debt instead of contributing to an emergency fund is a better idea. That may be the case when the interest rate on the debt is so high it simply needs to be paid off.
For example, let’s say you owe money on three credit cards with interest rates of 24%, 17% and 12%. It might be a good idea to repay the debt you are paying 24% interest on quickly and then split your available cash between establishing an emergency fund and paying off your remaining debt. That way you have the best of both worlds: a savings fund to pay for unexpected expenses and less credit card debt.
You may also prioritize debt repayment when dealing with debt in collections. This type of debt can drag down your credit score -- and having debt collectors harassing you may also be causing you stress. In this case, prioritizing repayment may be as much for your credit as for your mental well-being.
But while a debt may be looming overhead, it may not be worthwhile to repay it. Consider the type of debt you’re repaying, for example. As Cook emphasized, not all debt is bad. So, repaying it may not be a huge priority.
Borrowing money to attend medical school, for example, could land you in a lucrative career. And if you have federal student loans, you may qualify for an income-driven repayment (IDR) plan, which adjusts your monthly payments according to your discretionary income. You could use this type of repayment plan to lower your monthly payments while you repay higher-interest debt or save money. Once your other debts are repaid or you’ve saved up an emergency fund, you can move off of IDR – or stay on it, if you need the extra cash flow. (Just keep in mind that an IDR plan can keep you in debt longer and cost you more in interest than if you stayed on the Standard Repayment Plan that federal student loans start on.)
If you have debt from poor spending habits, though – say you like to go on frequent shopping sprees – then you’ll have to do more than just handle your debt; you’ll need to learn healthier spending habits. Otherwise, you’ll always be in a cycle of charging up debt, repaying it and then falling right back into debt.
Tips to set up an emergency fund and pay off debt
Since most consumers will likely find themselves paying off debt and establishing an emergency fund at the same time, here are some tips to make that process easier.
- Review your expenses and cut out unnecessary spending. This will increase the amount of money you have available.
- Set up a separate account as your emergency fund so you aren’t tempted to touch the money for something else.
- Make sure you make at least the minimum payment on all credit cards so that having the debt won’t have a negative impact on your credit rating.
- Try to make a regular monthly transfer into your emergency fund, no matter how small. Regular contributions will eventually help you build the fund you need.
- Have a strategy for repaying your debt when funds become available. Many consumers choose between two strategies — the snowball method, where you pay the smallest debt balances first, and the avalanche method where you pay off the debts with the highest interest rate first. Many consumers prefer the snowball method because it gives them the psychological satisfaction of paying off many debts quickly.
- Make sure your emergency fund is easy to access in case of an emergency and earning the highest possible interest rate to help the fund grow. Right now, many online savings accounts are paying higher interest rates than brick and mortar banks.
The benefits of having an emergency fund are undeniable. When an emergency hits, big or small, you have the resources you need to cover it without having to take on new debt.
For those who have credit card balances, it’s probably a good idea to build up a small reserve fund and then begin to repay your credit card balances more aggressively, splitting money between the card balances and contributing to your emergency fund. When you are done, you will have repaid your high interest credit cards and will have a fund to help meet emergency needs.