It is unlikely you will find a savings account that gives as high an interest rate as paying your debts saves. So it would technically mean that you will save money on interest by paying the debt off first.
However, this principle fails to take into account one key point. Emergency expenses occur in life, things that we cannot foresee. Without an emergency fund, you will find you self taking one step forward and two back (so you end up paying the interest on the debt anyway). The whole aim is to avoid acquiring new debt whilst paying off existing debt. Having an emergency fund gives you peace of mind and means that you are able to avoid a crisis. Also when an incident occurs, you money can still go towards you debts and you are able to pay off at the same pace and momentum.
I advocate building up a small emergency fund, that doesn't take too long to build and then once you have that in place start paying of the debt. But make sure you are making all your minimum payments. I think that a 6 month + emergency fund whilst paying off debt is overkill, even though there is more employment uncertainty in this economic climate. There is no set amount that works for all, you need to asses the likely risk of an emergency. If you have little assets such as living in college halls, no car etc then you would need a much smaller emergency fund than someone has a home, cars, children etc. I would say that a £1000/$1000 is a good starting point and adjust this amount up and down depending on your level of assets.
This amount should also be guided by your amount of debt, if you have a smaller amount of debt and it is going to take less time to pay it off, then statistically speaking there is less time in which for an emergency to arise (and less time to have multiple emergencies). Conversely, the more debt, the longer it will take to pay off the more chance of emergencies occurring. Its all about that debt to income ratio.
However, one of the problems of building a emergency fund whilst getting out of debt is that you may not have the right mindset yet. Be sure that you can avoid the temptation to spend that money unless it is an absolutely emergency.
By using a hybrid approach you are achieving both necessary goals of building an emergency fund and paying of debt.
Ultimately the approach has to be your own as only you know the nature of your debt.
One of my main goals right now is to get my emergency fund fully funded. My wife and I keep trying our best to get this done but when we are close we always have an emergency which depletes exactly what we spent so much time to save.
ReplyDeleteI started 2015 with two goals in mind, Pay off my debt completely and build an emergency fund. During the year I had to put one of those goals on hold and I decided it would be the emergency fund. I thought I would be able to accomplish both, but my emergency fund goal was a bit unrealistic, given the amount of debt I have.
ReplyDeleteI agree. When I was in debt, I made it a goal to keep my emergency fund at $1,000 and as soon as I was debt free, I made it an immediate goal to get that up to $5,000 with a long term goal of having $10,000 in there. It definitely saved me from going further into debt at times.
ReplyDeleteIt is amazing how many emergencies pop up when you don't have any money saved and on the opposite, how fewer emergencies come around when you do have money saved.
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