Why an Emergency Fund is More Important than Paying Off Debt

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.

emergency fund vs paying off debt

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.

12 Responses to Why an Emergency Fund is More Important than Paying Off Debt

  1. Having an emergency fund has always been really important to me. I’ve known a lot of people don’t have one and then when an emergency happens they panic and take out loans or use credit cards. For me it’s more about emotional security and knowing if something happens I’ll be OK, than about the actual money.

    • An emergency fund was one of my first financial objectives as a teenager. I’m glad that I had the discipline to do so at such a young age, because I still have the fund to this day.

  2. Good post JP! I would agree that this can be a touchy subject r many in the PF sphere. While I will generally say that paying off debt is vital and should be a major goal, having an E-Fund is even more vital in my opinion. If you start out with $500/$1000 in an E-Fund that will often take care of many things. From there you can focus on putting away a little each month and then knocking down that debt.

  3. The idea of having an emergency fund is very appealing, though some people may disagree that it’s more important than paying off debts. I think it’s good for our peace of mind and it helps to make us feel more comfortable about our future finances.

  4. I’ve been using the Dave Ramsey 3-step approach, but I’ve decided that $1000 simply isn’t enough of a buffer against emergencies. This year, I’m building it up to $3000 instead. In fact, that’s the topic of today’s post!

  5. Having an emergency fund is a staple but I would say it’s not a requirement. I tend to caution myself when making blanket statements because everybody’s situation is different. For example if someone is in the military they know for a fact they will always receive a check at the end of the month. Therefore if they do decide to have an emergency fund it should really only be approximately $500-$1000.

    • Normally, I too am weary of blanket statements, but I’m confident in this one. Military careers are easily ended with a debilitating wound. A robust emergency fund might be even more important given the work hazards.

  6. An emergency fund is definitely a top priority. Having that cushion of money that’s available if need be, not only makes life easier, but provides you a peace of mind. We’ve been focusing on both – making extra payments on the mortgage (put towards the principal) and saving/investing extra money. If we didn’t have savings – that would definitely be our primary focus.