Emergency Fund Vs. Paying Off Debt

When you are beginning to take control of your finances, you may need to choose between establishing an emergency fund and paying off your debt. It is important to have an emergency fund and to get out of debt as quickly as you can, but how do you choose which one to complete first?

Emergency Fund

An emergency fund is money set aside to cover unexpected expenses, such as a car repair, a medical emergency or a job loss. As you become more proficient at budgeting and have more money available, you may be able to handle many of these issues by managing cash flow. An emergency fund can also be used when you lose your job and a fully funded emergency fund should have about six months of your living expenses set aside. This money will allow you to continue paying your bills while you are looking for a job and can prevent you from losing your home to foreclosure.

Getting Out of Debt

The benefit of getting out of debt is that it frees up your income each month to go toward other things. You can begin to really build wealth once you are debt-free. Additionally, if you have fewer monthly obligations it is easier to cope with emergencies, such as a job loss or unexpected bills. However, getting out of debt may take time, depending on the amount of debt you have accumulated and your current income. You will need to sacrifice your current lifestyle and make cuts to find extra money to put towards debt.

Choosing Between an Emergency Fund and Getting Out of Debt

Look at your current situation and determine which is more important for you. If your job is stable, begin getting out of debt as quickly as possible. If you feel that your job is not stable or that you may have large medical bills in the near future, you may want to build up your emergency fund first and then work on getting out of debt. In most cases, it is better to get out of debt first because you can build the emergency fund more quickly if you have no debt payments each month. You may compromise by contributing a set amount to your emergency fund and then putting extra money towards your debt.

Miniature Emergency Fund

If you are going to pay off your debt before building your emergency fund, you should set aside $1,000 to $2,000 to cover the smaller emergencies you may face while trying to get out of debt. This money is important because it will prevent you from financing those emergencies with your credit card. If you tap into these funds, then apply the extra money you are paying towards debt until you have built up your emergency fund again. Then you can resume paying off debt.