Pay Off Debt Versus Saving for an Emergency Fund

Have a lot of credit card debt?  Wondering if you should put all your extra money toward paying off your debt or starting an emergency fund?  There really are two sides to this question.

First, you might think paying off your credit cards would be the way to go.  You have high interest on these accounts (in excess of 15-20%), so logically speaking it makes sense to try to get that knocked out prior to saving any money.  Savings accounts only make 1% right now, if you’re lucky (unless you get a 3% high interest checking account, like we did).  Either way, it’s way less than what you’re paying on your credit cards.  So, mathematically speaking, you should pay your credit cards off first, right?

Well, mathematically speaking, yes.  Just like when paying off credit card debt, this decision is as much about (or more than) psychology as it is about math.  If you put all your extra income to credit cards, you will have no extra income to handle any emergency situation that comes along.  Say something happens where you need some extra cash (got in an accident and need to pay your deductable, got sick and have to pay doctor’s fees, furnace goes out and you need a new one, etc.).  If you have no emergency fund, what are your options?  Put the money on your credit card!  What happens if you lose your job?  Then you have no income to make payments for anything, including your mortgage/rent, utilities, car insurance, etc.  So an emergency fund is a necessity for peace of mind, too, in addition to help keep your credit cards as low as they can be.

So what’s my recommendation on this situation?  I’d save all my extra cash to build up a $1000 emergency fund, which will handle most emergency situations (no that does not include needing to get your nails done, or buying the latest and greatest iPhone).  Once I got to the $1000 emergency fund, I’d put all my extra cash into the credit cards, following the previous article I wrote on paying off credit card debt.

Once the credit card debt is paid off, I’d go back and add 3-6 months expenses in an emergency fund.

How To Pay Off Credit Card Debt

Are you one of the millions of Americans that are burdened with credit card debt?  Do you have multiple credit cards, each with high balances on them, and feel overwhelmed about it?  You can get out, but it will take a lot of hard work and discipline to become debt free.  You have to really want to be debt free.

If you determine you really want to become debt free, you can do it.  First, determine how much extra you can pay per paycheck.  If you aren’t sure how much, pick a low amount (even as low as $5).  You can always increase it later.  Then, gather all your credit card statements.  Figure out the outstanding balance and interest rate on each card.  Now, you have two choices on how you want to approach eliminating your debt.

Mathematically speaking, the best way is to pay the minimum amount on each account except the one with the highest interest.  Take your extra money, and put all of that toward the one with the highest interest.  When that is paid off, take your extra amount PLUS the minimum payment of the account you just paid off, and use that amount as the extra on the next highest interest card.  Continue this process until you eliminate your debt.

But paying down debt isn’t just about the math.  Sure, it will get you out of debt quicker, but it doesn’t matter if it’s psychologically too tall of a mountain to climb.  Dave Ramsey recommends what he calls the “debt snowball” way of paying down debt, which attacks the psychological aspect.  Instead of putting all your extra money toward the highest interest debt, put it all toward the one with the lowest balance.  That way, you can get some quick wins, and eliminate entire bills quickly.  That will help give you the motivation to continue moving forward on the higher balance cards.  When you pay off a debt, move on to the next lowest balance.

In either case, make sure you continue to pay the same amount toward your total debt.  When you pay one debt off, make sure you take the principle for that debt plus the extra payment, and roll that into the next debt.  This is how you can really start to notice progress with each debt that gets paid off.  For instance, say you have the following debts:

  • $1000 balance with 15% interest – minimum payment of $30/mo
  • $5000 balance with 10% interest – minimum payment of $100/mo
  • $10,000 balance with 20% interest – minimum payment of $208/mo

If you were to pay just the minimums on these credit cards, it would take you 51 years and 4 months to pay off your debt at $338/mo, and you would have paid a total of $53,300.42!  If you follow the advice in this post, and add $100/mo to your total debt, you would pay a total of $438/mo.  You would be debt free in 4 years and 2 months, and would only pay $21,558!  Even if you only add $5/mo, but still roll your principle payments into the next credit card once the previous ones are paid off, you would be debt free in 6 years and 2 months, and only pay $25,062.09.

I’m sure you could think of a lot of things on which to spend the difference of around $30,000.  If you really want to be ambitious, you could take that $438/mo you were paying on credit card debt and start investing it once you’re debt free.  It wouldn’t change your standard of living any, and it’ll help you out a lot when you retire (but that’s a whole other post).

In addition to making these extra payments, don’t use your credit cards anymore!  Put your credit cards in a locked safe, and put the key in a difficult to reach place.  Or put your cards in a bowl of water, and put that in the freezer.  If it takes you time to let it thaw out, it’ll be that much more difficult to use.

In order to not use your cards for emergency uses, you need to save up a baby emergency fund.  Dave Ramsey recommends $1000 for people trying to get out of debt, and I think that makes a lot of sense.  So take your extra payments, and put them toward the emergency fund of $1000 first.  Set up automatic transfers on pay day until you reach the magical $1000 mark.  Don’t use that money for anything, unless it’s truly an emergency.  Note: an emergency is NOT any of the following: getting the latest iPhone, getting the oil changed on your car, paying car insurance, etc.  Those should all be planned expenses, and money should be saved ahead of time for them.  Once you reach $1000, then take the same amount and put that toward your credit card, in whichever of the two methods mentioned above you choose.

Here’s the real key to make all this happen – automatically schedule the payment the day you get paid.  Set it and forget about it.  Most banks allow you to set up automatic payments online.  If your bank doesn’t, switch banks!  If you get paid every two weeks, set the auto payment to go into effect every two weeks on the day you get paid.  If you start small, and realize you can live on less, you can adjust it later.  The key is to set up auto payment, and to set it on the day you get paid.  That way, you won’t spend the money on anything else.  Pay your debt first, then live off the remaining.

I am doing this right now with our student loans.  I’m taking the lowest balance first approach, and have already paid off two smaller loans.  A third one will be paid off by July of this year.  It’s really motivating when you have an entire payment disappear.

None of this is complicated.  It’s all pretty straightforward.  The hard part is actually being disciplined enough to go through with it.  Decide you want to get out of debt today, and start making progress.  Otherwise, you’ll be paying on your credit cards for the rest of your life.