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Should you pay off debt or create an emergency fund first?

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Deciding whether to pay down debt or save for an emergency is an important decision, but you may be able to do both.

Since the start of the pandemic in March 2020, 42% of credit card holders who already had debt have seen the amount grow, according to a September 2021 Bankrate survey of 2,400 American adults. Meanwhile, only 4 in 10 Americans have enough savings to cover an unplanned expense of $1,000, according to a separate Bankrate survey from January. Bankrate, like NextAdvisor, is owned by Red Ventures.

The most important thing is to take an honest look at your financial situation and then immediately establish helpful habits, according to two experts we spoke with. Here’s what you need to keep in mind when making your own plan.

What to consider when deciding

You want to see the interest rate on your debt and allocate your cash accordingly, says certified financial planner and financial psychologist Brad Klontz. If your rate is low, you could split 50/50 between paying down debt and emergency savings, and if it’s high, you could do 90/10 with a focus on debt. “When the habit is established, you can change the amount of money you’re putting in each direction, but you’ve set up all the pipes,” says Klontz.

At the same time, you want to do what makes you feel successful in your debt repayment process, says Summer Red, AFC®, senior education manager at the Association for Financial Planning and Counseling Education. “You would probably have less emergency savings to be able to pay off that debt faster,” she says.

When should you build an emergency fund first?

Ideally, you’d have at least one benchmark emergency fund, but if you don’t have any emergency savings, it’s a good idea to put some money away right away. While experts generally recommend at least three months, you don’t necessarily need them right away. Start by saving enough money to help cover an unplanned expense, like a car or home repair, or a large medical bill. “Then it might be time to tackle debt repayment,” says Red.

Once you’ve saved some money for emergencies, be careful to leave it untouched and for emergencies only. “If you don’t maintain your car, so it breaks down every couple of months, you may be using your emergency fund for something that isn’t strictly an emergency,” Red says. Instead, you can add up the expenses. like birthdays or oil changes, divide by 12 and save that amount every month, she says.

The goal is to start saving money regularly, no matter how small the amount. “For some people, $100, that’s not a lot. In a year or two, that’s a substantial amount of money,” says Klontz.

Can you build savings and pay off debt at the same time?

Configuring both pipelines helps start the process. “I’m a strong advocate of doing everything now, without waiting,” says Klontz, adding that too many people put off saving while paying off debt. “Because life goes on and you didn’t set up that account.”

pro tip

Automating your debt payments and savings can help you avoid late fees and grow your emergency fund.

Once you’ve secured your baseline, you can direct more money toward paying down debt. Interest rates are another thing to consider, Red says. The interest rate on your debt is likely to be much higher than the interest you’ll earn on a savings account. In other words, you’ll likely pay more in interest owed on your debt than you’ll earn in interest on your savings, Red says.

You might also consider a balance transfer card to help you pay less interest on your credit cards and leave more cash for emergencies. A balance transfer card will allow you to consolidate higher-interest debt onto a single new card that carries 0% interest on the balance transferred for 12 months or more, depending on the card.

Before you open and use a balance transfer card, make sure you have a plan to pay off the balance before the promotional interest rate expires. Otherwise, you could end up in another cycle of debt when the higher normal interest rate kicks in.

How much should be in your emergency fund?

Experts often suggest that you have three to six months of living expenses in your emergency fund. “It used to be pretty consistent three months into 2008, and then we had a devastating hit to the economy, and that’s when it stretched,” says Red.

Of course, how much you’ll need depends on whether it should be used for something smaller, like a basic car repair, or something more traumatizing, like losing a job. “If you’re in a field where there are only a certain number of positions or you’re very well paid, it can be hard to replace that income, and you may want a little more padding there,” says Rojo.

For longer-term financial emergency scenarios, consider a tight budget that cuts your expenses down to just essential living expenses. To find an emergency fund that works in that scenario, you can cut back on expenses like streaming subscriptions, clothing, or other discretionary expenses until you have a stronger foundation.

You’ll also want to consider your levels of anxiety and security, and whether they’re getting in the way of your quality of life. “How important is having an emergency fund to you, on an emotional level?” Klontz says.

Ways to tackle debt faster

Look at your spending habits

Paying off debt starts with looking at how the debt came about, so you’re not just putting a Band-Aid on the problem, says Klontz. “What is the mindset? What were the events? How did you get here?” he says. “If you don’t figure out how you got there, and how to stop the bleeding and heal whatever it is, you’ll end up back there again.”

This is especially true when you consider that many people have tendencies that impede their efforts, such as buying things on sale that they don’t really need, Red says. “’See this, it’s 8% off?’ And it’s like, ‘Okay, that dress is lovely, but you have four closets full of dresses with the tags still on.’ Have you tried paying off your credit cards?’” he says.

Snowball methods vs. avalanche

Being able to cover the minimum of your debts is essential to avoid charges, and after that you have some options. Tackling the smallest debt first and then rolling your cash onto the next lowest debt is called the snowball method, and paying off the debt with the highest interest rate first is called the avalanche method.

While prioritizing debt with the highest interest rate will cost you less, it’s about what encourages you to stick to a plan. “If you’re someone who’s motivated to save every penny possible, choose your interest rate first,” Red says. “If you’re someone who has struggled to pay off debt for a long time, maybe just paying one will be really satisfying It will help you move on.”

Automate your payments and savings

Setting up automatic payments can also help you reach your goals. “That’s where the magic happens because you’ll forget about it,” says Klontz, who says people tend to leave things as they are. “You’ll go back to your status quo bias, and before you know it, you’ll have made great progress on those goals.”

Canceling an automated gym membership, for example, is difficult because you have to admit that you don’t prioritize your health, says Klontz. But when you automate something that works for you, the status quo bias helps. “If you’ve set up an emergency fund or a college savings fund, the mental energy you have to do is go in and say, ‘I’m going to steal from my son’s college fund,’” he says. “Imagine the goal. When there is no goal, the money disappears,” says Klontz.

Automating your debt payments also helps you avoid late fees and can reward you after you’ve paid off a debt or received extra income, like a tax refund or bonus at work. “Use part of it for something fun, but then use the rest for financial goals,” says Red.

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