3228-3230 Eastern Avenue, Baltimore, MD 21224
Aug 17

Should I Pay Off Debt or Build an Emergency Fund?

Should I Pay Off Debt or Build an Emergency Fund?

The answer is: both.

Seems impossible some days, though, doesn’t it? However, as we hear more about the risk of post-pandemic inflation, it’s important to be prepared financially so you can manage your risk. Having a solid financial plan in place, and taking steps toward a financial goal (even if they’re tiny steps), gives you a lot of peace of mind. Let’s answer a few basic questions to get you on the path to greater financial freedom.

When should I start saving? You should start with your first paycheck; whether that is from a paper route or a tech startup, it’s important to create a savings habit. Never stop saving – especially for retirement. Even a small amount put away in your 20s, adds up quickly with compound interest to something significant in your 60s. So, while sometimes the urgency of debt payments makes you feel a little panicky, it’s still always a good choice to be setting at least a little bit of money aside regularly.

What’s more important, retirement savings or an emergency fund? The answer to this question can be a little murky. Retirement savings is critical. If you have an employer that matches your retirement contributions, you should always save at least the amount matched by your employer. For example, if your employer will match your contribution up to 5% of your annual salary, then at a minimum you should be saving 5%. If you aren’t doing that, you’re turning away free money. Who can afford to do that?

An emergency fund of three to six-months’ worth of expenses is another important investment because it can help break the debt cycle. If you are having to resort to a credit card every time your car needs a repair or you have a medical expense, you are digging yourself deeper into a hole. Having an emergency fund will help you have available cash to cover those expenses. Remember to rebuild that emergency fund after you pay for an “emergency”. For a short period of time, it may be smarter to focus on building your emergency fund and only paying the minimum due on your debt. Once your emergency fund is firmly established, you can redirect those contributions toward your debt reduction.

But how do I build an emergency fund and still pay off debt? In a word: budget! Building a budget and regularly reviewing your expenses and income will help you be more aware of and accountable for your money management habits. It’s likely you will find opportunities to reduce your expenses. Those reductions can go directly toward your debt payoff. Here are a few options to make more income available:

  • If things are really tight, and student loans are the bulk of your debt, you can often restructure those loans or use a forbearance or deferral to help you get back on track financially. Credit card debt doesn’t have those options, but moving your credit card debt to a low-interest or no-interest credit card, even if it’s only for a promotional period of one year, can help you to get a better handle on your expenses, while minimizing the interest accrual.
  • Consider taking on a side job and devoting all of the income from that to an emergency fund. Use the income from your “day job” to cover your debt obligations. Once you’ve saved three to six-months’ worth of expenses in your emergency fund, you can divert the income from your side job to your debt repayment.
  • If you have good credit, and a home mortgage, you might consider refinancing your mortgage to take advantage of lower mortgage rates. Use the savings from that lower monthly mortgage payment to either build your emergency fund or pay down debt. It’s unwise to refinance your mortgage to pay off credit card debt.

While it may seem impossible at first, be patient, take small steps, be honest about your spending/saving habits, and you will be surprised at how quickly you can begin building a more financially secure future. Your neighborhood banker at Homewood Federal Savings Bank can help you create a financial plan and show you the tools that will help you achieve your financial freedom.