Payoff Debt vs Save for an Emergency, What To Do? – Part 1

See if this scenario sounds familiar – fresh out of college, just started your first job, and not a penny to your name. Plus, you are up to your ears in student loans, credit card debt, car loans, and maybe even parental loans—oh, boy!

You probably have a variety of debt and most people do….. and that’s ok. When you are starting out on your own, this is common…. but it doesn’t need to be overwhelming.

So which debt should you focus on paying off first? And I need money for an emergency! What to do?

emergency

First off, let’s look at the pro’s of each.

Paying Off Debt

Here are some of the pro’s:

Getting rid of debt can remove mental burden or mental stress

Debt can feel like a Rock of Gibraltar-sized weight on your shoulders. Paying off debt can alleviate the tension and stress it places on you. Paying off debt feels good! It feels like you are accomplishing your goals and making positive strides in your life.

Paying off debt can improve your credit score

Another great benefit of paying off debt is improving your credit score. Especially when starting out, your credit score is probably low due to all the debt accumulated.

A high credit score will enable getting a low -interest rate loan thereby enabling more of your money to go towards the principal not the interest on the loan. This is great for large purchase items such as a new car.

Paying off debt allows focusing on other financial goals

If you have future goals such as buying a new car, buying a house, buying rental properties, etc. paying off debt will go a long way towards those goals.

Eliminating debt allows the focus to shift from debt reduction to asset accumulation. If you have other financial goals in the near future such as the purchase of a home, it might be prudent to focus on paying off your debt first.

The faster you payoff debt, the less interest paid over time

The beauty and burden of compound interest is that it can work for or against you depending on if acquiring assets or paying off debt.

From a debt standpoint, let’s assume $5,000 balance on a credit card with 15% interest, and you only make the minimum payment every month. In reality, you’ll spend much more than just that original purchase price.

Using Bankrate calculator, over the course of your repayment, assuming a 3% minimum payment, you’ll spend over $1508 in interest. In other words, that $5,000 loan actually costs $6508. Yikes!

Paying off debt quickly allows the amount of interest paid on a loan to be minimized. This means more money in your pocket, not the bank’s! 😊

Building Emergency Savings

Here are some of the pro’s:

Peace of mind you have a safety net to cover an emergency

Emergencies will come up and not being prepared can put you deeper into debt. Having a sufficient emergency fund acts as a safety net that provides peace of mind needed to weather an emergency. An added benefit is having an emergency fund prevents future debt from accruing since a credit card would probably be the means used to payoff the emergency.

Taking advantage of the benefits of compound interest

Back to my above statement about having compound interest work for or against you. In this case, the sooner you save money, the sooner compound interest will allow money to grow and work in your favor.

Here is an example of compound interest working for you:

Let’s say that $5,500 a year is added into an individual retirement account at age 25. If you continue to save that same amount until age 65, earning a 7% return, you’d have $1.17 million saved for retirement. However, if you wait until age 35 to start, your retirement nest egg would grow to about $556,000.

Avoid using new debt to cover an emergency

The reality is that if an emergency fund does not exist, that additional debt must get paid and choices are limited. A person can borrow money from family or friends which increases the debt already owed.

A more common approach is to put the debt on credit card which amplifies the debt owed due to the high interest rates credit cards charge. Either way may resolve the situation, but it does not benefit you in the long run.

Enables working toward financial goals on your own timeline

Developing a sufficient emergency fund (> 6 months of expenses) enables choices on how to spend excess money earned each month. Choices are always good! 😊

A person can treat themselves to a nice vacation. They can choose to invest the money in stocks, bonds, real estate, etc. A home can be purchased. That student loan or credit card debt can be paid off.

Whatever is decided, having an emergency fund enables good things to happen.

Questions You Need to Ask Yourself

If contemplating what approach to take (payoff debt, build emergency fund, or both), ask yourself the following questions.

What is My Job Situation?

If your job is in high demand, the economy is strong, and you’re getting Rockstar -level performance reviews, chances are your immediate need for an immediate emergency fund is low and you can focus on debt payoff. However, if the economy is weak and it looks like layoffs may be coming, it is probably better to focus on cash conservation and building up the emergency fund because you may need it.

Do I Have Any Emergency Savings Already?

If your family gave you a few thousand dollars at your college graduation party, you probably have a low immediate need for an emergency fund. In reality, most of us start our working lives with little or no money in the bank and all our worldly possessions can fit in the truck of our car. This is not a good situation to be in. It sucks being an adult and having to rely on your parents for financial support.

Odds on an emergency fund is needed, even if it just a month’s worth of expenses for now. We all need breathing room and an emergency fund enables that.

What Types of Debt Do I Have?

A lot of us coming out of college probably have a car payment, credit card debt, and student loan payments due. Usually a lot of it! High interest debt and large payments can really suck the life out of the funds you work so hard for. In this case, it may be better to payoff some of those debts 1st to give yourself breathing room.

Do I Have Others Levers I Can Pull in an Emergency?

Do you have a rich Uncle Bob who can cover you in an emergency? Do you have an inheritance your grandparents left you? Any old EE savings bonds people bought you as a baby? Any side hustle money you can lean on? Most of us don’t coming out of college or even a few years into their working careers. Lord know I didn’t right away….

Having levers (i.e. emergency help) you can pull in an emergency can help alleviate the need for savings in the short-term until debt is paid down.

Rule of Thumb

Which is the best approach?

According to the general rule of thumb, the best approach is to do both at the same time.

An option could be if no emergency money is currently saved is to weight contributions toward your emergency savings until a basic amount is reached (i.e. 1 months of expenses) while the remainder of the excess funds is put toward debt paydown.

For example, assume a person has $35,000 of after-tax annual income, $29,000 in annual living expenses (or $2416 per month), and no emergency fund. This leaves $6,000 in excess money (discretionary spending money) for distribution or roughly $500 per month.

A person could put the 5 months of excess money ($2500) in savings and thereafter put $100 per month in savings and the remaining $400 a month can go towards debt reduction. At the end of year 1, a person could then have approximately $3200 in savings.

Unfortunately, it is only about a month of expenses, but it sure beats the alternative of having to either borrow money from parents or add credit card debt to cover an emergency.

What I did

I followed something similar coming out of college. At that time, I had literally no money in savings and a massive amount of debt. I remember saving the minimum money in my 401K that triggered the maximum company match (cannot turn down free money! Lol 😊), putting $100 a month in savings and using as much discretionary income as I could to paydown debt as fast as possible. My focus at the time was on debt reduction.

If an unexpected expense came up, I had a few additional levers I could pull which also provided a safety net. My roommate and I rented a place that included everything, but electricity and cable so living expenses were cheap. I didn’t eat out very much so food costs were cheap too.

My biggest worry was my car breaking down and it did…a lot! I fixed that by leasing thru my company. They offered a SWEET deal in which the lease price included insurance, maintenance, etc. I calculated the expenses that I was paying on my 10+ year old Ford Escort and found out it was cheaper to lease AND I had a new car to boot!

Next, I could stop paying excess money on my debts for a short term until the emergency expense was covered. This was not a preferred choice but added more to my margin of safety.

Finally, I also had a HUGE “entertainment” budget (i.e. going to bars, sporting events, and traveling) I could fall back on if needed. I would simply stop having fun for a short while and use those funds to payoff any unexpected emergency expenses. Plus, I had a lot of good friends who I bought a lot of rounds for. When things were occasionally tight, they covered my bar tab… gotta love having good friends covering your six! Lol 😊

Using this method, in 3 years, I paid off about 30 – 40% of my debt and built up an emergency fund that would cover 6 months of expenses. Not bad, huh?

Looking back, I could have built up my emergency fund and paid down even more debt than I did. I wasted ALOT of money on stupid things. That money could have been better served paying down my debt faster, building up my emergency fund faster, putting more towards retirement, or developing other income streams which had more long-term benefits.

While it was silly how I spent money back then, when I reflect on those days now, I also realize those were some of the best times of my life. Why should you have a life if you can’t live it? 😊

What’s Next?

In my next article, part 2 for this topic, we’ll talk about techniques for paying off debt faster, including a new way not many people have heard about but has been working for me recently. We’ll also discuss if I could do it over again, what would I do. It’ll be an interesting and exciting conclusion to this topic …stay tuned! 😊

Live the Life You Want, Love, and Deserve 😊