Spare Cash: Pay Off Debt or Build Emergency Fund?
Financial experts recommend keeping about three to six months, even up to 12 months, of living expenses in a risk-free savings or money market account. The purpose of this “rainy day fund” is to help you survive a financial catastrophe such as losing your job, needing unexpected roof replacement, or large medical bills. The amount you should keep in your emergency fund depends on how stable your job is, how likely you are to have unplanned expenses, and the number of people that depend on your income.
But does the conventional wisdom — that everyone should have a substantial amount of cash savings — apply to you if you owe high-interest debt on your credit cards?
The most you can earn from a savings or money market account these days is about 5%. After you factor in taxes, your take home amount is substantially less — more like 3-4%.
Meanwhile, the interest rate you pay for most credit cards is in the double digits, often near 20%.
Mathematically speaking, it makes no sense to sock money away in an account earning a paltry 3-4% (after tax) when your credit cards are bleeding your wallet dry at close to 20%. You’d be far better off keeping no emergency fund at all and using that money that would be in savings to pay down your debt. As long as the interest rate on the money you owe is greater than the interest rate on the money you save, it’s best to use the money to pay down your debt.
How would you handle an emergency with no savings? You’d use your credit cards to take care of the problem. If no emergency arises, count yourself lucky: you cut your interest payments substantially.
But what’s best for your wallet in theory doesn’t always work out that way in practice.
The lack of savings and inability to limit your expenses (for whatever reason) is what got you into debt originally. Tapping your credit card for emergencies and pseudo-emergencies could dig you into an even deeper hole.
Consider this carefully. If you can know for certain that you won’t abuse your credit cards, then you should put all of your savings towards debt reduction. But if there’s any doubt in your mind, it’s better to build an emergency fund and pay a bit extra in interest than to rack up more charges and even more interest.
