Deciding whether to save for an emergency or pay off debt can be a tough choice. You are not the only one who faces this dilemma. Many people struggle to balance their budget or use their extra income wisely. In 2020, household debt, excluding housing costs, reached the highest level in 16 years, but at the same time, the household savings rate climbed to levels not seen since 1975. —Worldculturepost
Should you pay off debt or save? The answer is: You need to do both, but we’ll help you figure out what factors to consider when making this important decision.
Key Takeaways:
- Always make at least your minimum debt payment, and set aside some money for savings every month, even if it’s a small amount.
- Your personal situation can help you determine your priorities if you have to choose between two options.
- For long-term financial health, develop habits around paying off debt and saving money at the same time.
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| Emergency Savings or Debt Payoff: Rule of Thumb |
What Is the Rule of Thumb About Emergency Savings vs. Debt Payoff?
The general rule of thumb is to do both: Pay off debt while building your emergency savings. “If you only save and neglect paying off debt faster, you are missing the opportunity to commit to doing both now,” he said. “It should never be an either-or option,” said Todd Christensen, education manager at Money Fit by DRS, a nonprofit debt management agency.
If you postpone paying off debt until you save for emergencies or even retirement, but then never manage to pay off the debt, one day you may realize that it's time to retire and that you are totally unprepared—and, perhaps, still in debt.
You could allocate more money toward your emergency savings—for a while, at least. Christensen suggested saving up a small cushion—anywhere from $500 up to the amount of one month’s living expenses—if you don’t have anything saved right now. But keep paying more than the minimum on your debts.
For example, suppose you have $100 in discretionary funds per month to put toward emergency savings, debt, or both. In this case, send an extra $5 or $10 to each debt account, and concentrate the rest on savings.
"Discretionary" spending means the amount of money you can spare each month after your living expenses.
Take discretionary funds out of every paycheck as soon as possible, instead of waiting to see what’s left at the end of the month. “You never have money left over at the end of the month,” he said, meaning you’ve probably already spent it all.
Establishing the savings mindset, rather than buying whatever you want every month, will benefit you long-term, he noted. You’ll be more likely to transfer the former debt payment into savings when you’re done with the account.
Samantha Gorelick, a certified financial planner (CFP) with Brunch & Budget, a financial planning firm, recommended a different approach: Pay only the minimums on credit cards until you’ve built a solid savings buffer.
Start with one month of expenses, she suggested, then try to build up a few months of savings. Starting small is fine—perhaps auto-deduct $10 to $20 from your paycheck and sending it to a savings account.
"While it won't grow quickly, you're creating a habit of saving—which makes you a saver," Gorelick said. As you get more comfortable with balancing spending and saving, increase the amounts you transfer to savings.
If you stay invested for the long-term and keep making regular contributions, your money should at least see some growth and beat inflation. Historically, until 2018 the stock market has returned around 10% a year on average. Your money also compounds in a tax-deferred investment account such as a 401(k) or IRA, so it can grow even faster. Missing out on one or two great years could make a big difference in your total savings.
If you are paying off the debt and saving at the same time, you should end up on stronger footing than you otherwise would be.
Saving Money or Paying Off Debt: How to Make the Best Choice?
There is no one-size-fits-all answer to this question. But there are some factors you can consider to help you decide whether to focus on paying off debt or putting away money in a high-interest savings account. Ask yourself these questions:
How Stable Is My Job?
If you are not confident about your job security, prioritize emergency savings. That’s because if you pay off debt aggressively, then lose your job, you still don't have any money even if you have no debt, which leads to more card use, and more debt, Gorelick said. If you have savings, that can help you avoid using too much credit card in case of a layoff or shutdown.
Christensen agreed, adding that having some savings gives you more flexibility when looking for a new job. “The worst thing that can happen when you lose your job and have no emergency savings is feeling like you have to take anything, anything,” he said. “You end up in a lower-paying job. Later, when you try to get back to the kind of job you had before, future employers question what happened when they see your resume. It’s a hard situation to be in.”
On the other hand, saving could be a smart move if your employer matches the contributions or a part of the contributions that you make to your 401(k). With a 401(k) match, you are getting an immediate return on your money. Think of it as a bonus or a salary increase. It's free money. So save at least up to the amount your employer will match, usually anywhere between 3% to 6% of your salary. One exception to the rule is if you plan to leave your employer before being vested in those matching contributions.
How Much Do I Have in Emergency Savings?
To figure out how much you ultimately need in emergency savings, one general rule of thumb is to take your annual income and divide it by $10,000, Christensen said. The resulting number is how many months of living expenses you’ll need in savings until you find your next job at the same pay.
If you earn $30,000 per year, for example, save up three months’ worth of living expenses. If you earn $60,000, you need six months’ worth.
If you notice that you're using your savings every month—instead of adding to it—Gorelick suggested reviewing your budget. Lower your monthly contributions, and focus on keeping your expenses within your available income.
Do I Need Other Savings?
Christensen noted that “expected” expenses sometimes can be just as challenging as unexpected ones. For example, you’ll probably need to buy a car sometime in the next five to ten years. But if you’re not saving for that car now, you’ll be at the mercy of the lender where interest rates are concerned. Other “expected” expenses might include appliances or home repairs. Instead of having to use your home equity to get a loan for those things, you could use a dedicated savings account for planned expenses.
Make your savings hard to access—so you’re not tempted to be a “savings raider,” Christensen suggested. Keep cash in a bank that’s harder to access physically or online, separate from where you do your regular banking, for example. In a true emergency, you want to be able to access the money within a day or two but not expose it to splurging whims.
What Kind of Debt Do I Have?
Some debts have extremely high interest rates—such as payday, car title, and pawnshop loans, which can have an annual percentage rate (APR) well over 100%. If you have any of these, you’ll want to put as much as you can toward those kinds of debt, Christensen pointed out. Put something into your emergency savings fund, even if it’s $1 or $2 each month.
Other lower-interest debts, such as mortgage, car, and federal student loans, are still important to pay on time, but they may not be as urgent to pay down if you need to build your emergency fund.
The higher the interest rate, the more you’ll save from paying off the balance quickly.
Due to the temporary pause on federal student loan repayment during the pandemic, you could take your monthly loan payment and put that toward emergency savings, Gorelick noted.
Am I Expecting a Possible Windfall?
If you receive unexpected money from a government source, family member, or employer, spend it smartly. Christensen suggests the following formula as a rule of thumb for how to use that windfall if you’ve already got some savings:
- 30% for needs—e.g., replacing broken appliances or repairing your car, to avoid debt in the future
- 25% for paying off debt
- 20% for savings
- 15% for long-term investment
- 10% for fun spending
However, if you have no emergency fund, consider this formula:
- 35% for emergency savings
- 30% for needs
- 25% for paying off debt
- 10% for fun
Grain of Salt
Rules of thumb are general guidelines that might not work for everyone. You may need to take such rules with a grain of salt in your situation.
For example, if you’re behind on credit card, house, or car debt payments, catch up on those before building an emergency fund, Christensen stressed. Some unpaid loans, such as a car note, could cut off your access to work and other life necessities.
But even in that situation, “If you can put just a dollar into your emergency fund, you’ve saved something. Being a saver is a lifetime choice, not a just choice until we’re out of the economic downturn. If more people saved, we’d probably never see another payday lender again. They wouldn’t be necessary.”
If you're unsure, speak with a licensed financial professional or nonprofit credit counseling agency to get the best advice specific to your situation.
Frequently Asked Questions (FAQs)
How can I pay off debt faster?
Paying off your debt faster requires focus and strategy. The debt snowball and debt avalanche are two popular methods. With the snowball, you'll pay off your debt by putting as much as possible toward the smallest debt, then rolling that extra amount to each progressively larger debt as you pay off each one. With the avalanche, you'll take a similar approach but start with the highest interest rate and work your way down. In both cases, you'll gain momentum as you finish each debt.
How much money should I save every month?
If you're just starting to save, one general rule of thumb is to start by saving 10% of your income each month. Create a budget, and if you find that you can save more, then do so. That is a great place to start the habit of saving, and you can increase as you find the room in your budget.