I’m often asked whether or not you should save money in an emergency fund, or pay off debt first. While a lot of people may argue you should pay down your debt first, I know firsthand how important an emergency fund can be.
According to a USA Today poll of over 1,000 participants, 34% had no emergency savings AT ALL! That means they can’t pay for a simple car repair, or the $650 dental bill I got last month. It also means when these situations come up, people are putting them on their credit card and going even further into debt. The poll also revealed 47% of participants couldn’t cover their living expenses for more than 90 days.
Before paying off your debt, you should have three months’ worth of living expenses saved in your emergency fund. When calculating your living expenses, include your necessities- rent/mortgage, utilities, cell phone, etc. Gym memberships and other entertainment can be cancelled or cut back on in the event you lose your job and therefore aren’t as crucial. You should however factor in how much you spend on weekly groceries, and don’t underestimate it.
Once you decide how much to save each month or bi-weekly, set up automatic deposits into your savings account. If you’re waiting until the end of the month to move money from your checking account to your savings account, you probably aren’t because there isn’t much money left. I always have my monthly savings come directly out of my check.
Obviously you can’t ignore your debt and you will need to make the minimum payments until you have that three months’ worth of living expenses saved. Once you hit that savings goal I encourage you to start throwing more money at your debt, paying off your debt with the highest interest first. Typically a credit card will have a much higher interest rate than student loans, and even car loans. I like to have a decent amount in savings, so I don’t completely cut off my contribution to my savings account. I would look at how much you can save each month, and continue putting 25% of that into your savings while putting 75% toward paying down your debt.
How much money you have in your savings account is really personal preference. Having less than 4 months makes me uncomfortable but that’s not to say I haven’t been there. My husband and I had to put $79,000 down when we bought our home in June. Less than eight weeks after moving in, our hot water heater and furnace went out. Luckily we had the money in savings to pay for that ($6,500) unexpected expense, but between that and our house down payment it left us with less than 4 months of living expenses in an emergency fund. Since then we have been contributing more to our emergency fund each month and trying to cut back on non-necessities.
While paying down debt is important because the longer it takes you to pay it off the more interest you will have to pay, you can’t afford not to have money in savings. You will only accrue more debt when emergencies come up and you are forced to put it on your credit card. Start small and you’ll be amazed how quickly you can build up your savings account to three months’ worth of living expenses.