As you stare at your account balances, you wonder what to do. Should you put that bonus you just got onto your credit card or put it away as emergency funds? Reducing credit card debt by even a little can make a big difference, but emergency funds are essential to building your future.
Deciding whether to pay off debt or save for an emergency is an important choice, but you might be able to do both. The logistical consideration is about what kind of debt you have. Yet, there is an emotional component, too. The more successful you feel with your finances, the more likely you will make ongoing good financial decisions. So, consider both the logistics and how you feel.
What is an emergency fund, and why is it important?
Emergency funds cover unexpected expenses to carry you over until you get out of the situation. It could be waiting until your EI kicks in, a surprise appliance replacement, or a hefty vet bill. Or maybe you just got a notice for CERB repayment. The goal is to avoid putting things on your credit card and building up high-interest debt.
When should an emergency fund come first?
Ideally, you could dip into your emergency funds for any expense outside your regular budget.
Paying off debts may feel more important. Sometimes, it is better to prioritize some emergency savings. Without savings, you have to rely on high-interest credit cards in a crisis, which compounds debt and worsens the problem.
So, if you don’t have any emergency funds, consider a plan to start saving right away. Think about what might come up for you and set a goal to save enough to cover that. Put money away regularly, even a small amount. Experts recommend at least 3 months’ worth of your regular living expenses as a minimum balance. Though it’s best to keep adding to your savings account even after you reach that goal.
If you only have “good” debt, you can start to build an emergency fund right away. Good debt finances assets, usually at a reasonably low-interest rate. Setting up an emergency fund is always more important than extra payments on your:
- Student loan
- Car loan
- Credit cards you pay off every month
Can you build savings and pay off debt at the same time?
Yes! This is usually the best path to a strong financial foundation. If you put off saving while you pay off debt, you may find yourself disheartened. Savings make you feel like you are getting ahead, which is motivational!
Consider using your bank account’s automatic transfer system to pay your debts and make savings deposits. This helps develop positive financial habits for the future. Then, once you have a solid balance in your emergency bank account, you can shift some extra funds into paying off debt.
When should you use an emergency fund to pay off debt?
Sometimes debt is an emergency, so using emergency funds to pay off debt makes sense. Carrying debt impacts your credit rating, so you need to find a balance.
- Prioritize paying down your bad debt as you contribute to your savings. You can build your savings faster once you have your debt paid off. Deposit those same debt payment amounts to make your bank account grow!
- Redirecting your emergency funds makes sense when you have an immediate obligation to make a debt payment. Always make your minimum payments. Making a big dent in your “bad debt” can make a big impact when you get rid of high-interest rates. Credit card balances, payday loans and high-interest personal loans make it harder to reach your financial goals.
- If you will soon apply for an overdraft, car loan, or mortgage, consider making extra payments on your bad debt. This improves your credit score and debt-to-income ratio in the short term. Which sets you up to get a better interest rate on the new loan.
When shouldn’t you use an emergency fund to pay off debt?
Start by saving money if you don’t have anything in an emergency fund, have no “bad debt,” or want to avoid using your credit cards for unexpected expenses. Your savings account will earn interest, too.
Usually, using your emergency funds to pay off debt is not a good idea in the long term. There are other ways to tackle debt using good financial planning, without dipping into your security.
Other ways to tackle debt
Combine these methods of tackling debt to come up with a unique solution for your situation.
Snowball Method – List your debts in order by the amount you owe. Then pay them off, starting with the lowest balances first. Make the minimum payment on the rest. The satisfaction of having fewer bills is motivational enough to help you feel better as you pay off your debt.
Avalanche Method – List your debts in order based on the interest rate. Then pay off the balance with the highest interest rate first. Make the minimum payment on the rest. This approach is great if you have several types of debt, like credit cards, a car loan and student loans.
Bonus Method – Set aside any bonus money you receive to pay off debt. Extra hours from work, a tax refund, or birthday money. Any time you have extra at the end of the month, make an extra payment.
Fix Your Spending Habits – Whatever got you here will keep you here unless you do something differently.
Automatic Transfer – Take yourself out of the equation by setting up an automatic transfer with your bank. Let the system work for you!
Debt Consolidation – Debt consolidation merges your debts into a single, fixed monthly payment at a lower interest rate. You pay off your debt quicker and always know exactly how much you need to pay. No more sitting at the dining room table stressing out and contemplating how much to pay each creditor.
Saving and going into debt are opposing forces. Yet, you can pay off your debt and put aside emergency funds for greater security and peace of mind.
If your debt stands between you and putting together the funds you need, contact us today. Speak to a credit counsellor to make a plan to build your financial future.