You might not know this, but building an emergency fund vs.paying off debt is a touchy subject for many finance bloggers when it comes to which is more important.
Some believe that freeing yourself from debt is a critical first step to financial stability. They support their priority by arguing that by focusing on debt first, you save money in interest and get access to more money each month by paying debt off fastest. There are plenty of people who sit in the middle of the debate, but I’m neither a proponent of this priority nor a fence sitter. I strongly believe that an emergency fund should be the first priority for anyone beginning the journey of financial responsibility.
It’s my sister who has convinced me of this position.
Why My Sister Needs an Emergency Fund
My sister is great! I hope, should she be reading this, that I don’t embarrass her too much or cause her to hate me forever. However, her financial struggles are very educational when it comes to how important an emergency fund can be.
To start with, my sister is working hard to make smart financial decisions. She earns an average annual salary, but doesn’t have much left over at the end of the month. That’s because she has a relatively large student loan bill. For years now, she’s been trying to pay extra to eliminate the balance. There is only one thing that is really stopping her. She’d chalk it up to inflation, bad luck or just plain life. However, it’s all related to her lack of an emergency fund.
Last week she shared with me her frustrations over paying off her loans. It seems that every time she has extra money, something big breaks and she needs to use the money to make ends meet. In some cases, the unexpected situations have caused her to slip backwards in her goals, taking on temporary debt through credit cards.
It’s a frustrating situation, but there are several reasons why an emergency fund would make money much easier for her.
Earn Interest, Don’t Waste Money Paying for It
You won’t earn tons of money in interest by saving and putting an emergency fund in the bank. However, it’s better than the catch-22 my sister finds herself in.
As I said before, my sister doesn’t have much left over to pay down debt each month. Certainly not enough to handle surprise situations when they happen. As a result, she often taps into credit card debt to buoy her, even though it might be temporary. The effect of this is that she’ll spend more in credit card interest than she would have if she hadn’t been paying any extra towards her student loans.
For people who do not have much left over after monthly expenses, an emergency fund will actually save you money in interest paid. You’ll see that this drain on her budget is noticeable even if she can’t place her finger on the problem.
Earn More Money by taking Small Risks
Did you know that the most important characteristic to avoiding poverty is to hold an asset (an emergency fund is an asset)? Assets give you flexibility, and ultimately help you to earn even more money. Not just by earning interest, but giving you the needed courage to take small calculated risks.
When my sister asked me how she could earn a little extra money, without any risks, I thought I would swoop in with an easy reply. Her employer has an employee stock purchase plan that allows her to buy company stock at a discount. I won’t spend the next three pages boring you with how this thing works. Simply put, she’d need to put extra money from her paycheck in an untouchable escrow. After six months, she’d get it all back, plus at least 15 percent (last period returns were over 100 percent).
There was just one problem to my solution. My sister couldn’t part with the money. She knows that every few months an emergency happens and while she knows this month she could take the pay cut, next month might be different.
You know what? She’s right. The benefit simply wouldn’t work for her, because she really can’t afford to part with the money.
Hopefully, you see that an emergency fund would solve this problem. By having money to cover life’s lemons, she’d be able to earn extra money and pay off her debt faster.
Save and Pay Down Debt if You Must
For my sister, debt reduction is not the remedy for her budget. She’s spending more money on interest – not less. It’s not significantly reducing her balances and freeing up her budget. Worse still, she’s not able to take advantage of simple opportunities to earn even more money.
If you ask me, an emergency fund is a critical part of financial freedom and should come before debt reduction. If you must, pay a little every month into your emergency fund and debt principal – but don’t forget which is more important.