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Should You Build an Emergency Fund or Pay Off Debt?

An emergency fund safeguards against unexpected situations, protecting you from unforeseen expenses. But building an emergency fund is difficult when you are already repaying debt. If you have multiple financial goals, it can be tough to maintain them simultaneously. So this is a debate many of us face at some point: Emergency fund versus paying off debt.

Which option you choose to meet your goals depends mainly on your financial situation. However, here is everything you need to know before picking up one.

Emergency Fund Vs Paying Off Debt: Which One Should You Choose?

Paying off debt as soon as possible is important because the interest charges consume a lot of money monthly. Also, an emergency fund is equally important so you do not have to drown when something bad happens. But it is quite challenging to maintain both at the same time. Which should you choose, paying off debt or emergency fund? Let us analyse both to come to a decision.

Emergency Fund

An emergency fund is created so that you do not have to take any loans if a critical situation suddenly arrives, causing a lot of expenses. Emergencies include job loss, medical crises, a sudden car breakdown, etc. These kinds of situations are unforeseen and require a lot of money. Having an emergency fund will save you from high-interest debts in such situations.

Paying Off Debt

Carrying multiple debts can make people a bit desperate. Every debt has interest rates that add up to how much you owe. This way, you end up paying a lot each month. Paying down debt improves your CIBIL score. But in such cases, you end up paying more money for your borrowing than you are getting on your savings.

What to Consider When Deciding Between Emergency Funds and Paying Off Debt?

As discussed above, you should understand your situation to determine whether to start paying off debt or emergency funds. You should consider asking yourself certain questions before choosing any of the two.

The Interest Rates

If your debts include "good debts" like mortgages and student loans, you will probably pay much fewer interest charges. In this case, focusing on building an emergency fund seems fair rather than desperately paying down your debt. On the other hand, debts like credit card debts carry more interest rates, making it easy for the debt to build up. These types of debts require more money. So, individuals with high-interest debts should prioritise paying them down.

Your Monthly Expenses

First, you have to pay for your basic needs with your current money. It should cover essential expenses like groceries, rent, and electric bills after paying the EMIs. There is no point in setting up a fund when you do not have much cash left after paying for your basic needs. In this case, you should start working on paying off the debts first so that you can start saving afterwards.

Your Other Financial Goals

Building an emergency fund and paying off debts cannot be the only financial goals that a person could have. Goals like saving for retirement, saving for a car, investing in a health insurance plan or starting a new business are long-term investments that you need to keep working on for a long time. You must focus on reaching each of your goals without hyper-focusing on any of them. If you thoughtfully prioritise your goals, you can be on track to achieve both short-term and long-term goals.

Amount Saved for Emergencies

If you have not saved money for emergencies, you should start doing so. For instance, if you start paying off your debts aggressively without saving money, paying for emergency expenses will be difficult. If you have to start saving for your emergency fund from scratch, you should pay the minimum amount on your debt and save a small portion of your income so that it can cover unforeseen situations.

Amount Your Emergency Fund Should Contain

If you have a stable job and income, you should keep aside your six months' money as an emergency fund. This can cover basic emergency costs and save you from carrying another debt. However, if you are self-employed and earn irregularly, you should save more rather than pay down the debts aggressively.

When Should You Start Building Emergency Funds?

Whenever there is an argument about emergency funds vs paying off debt, everyone should choose to build an emergency fund. Although it depends totally on the individual's current financial condition, saving money for future needs is always advisable. If you do not have an emergency fund, you should consider building one when the following criteria match your money situation.

When You Want to Avoid New Debts for Future Needs

Suppose you are planning on buying a car in the next two years. It is better to save some money rather than take a loan. Planning for a large purchase and paying it from savings is a good plan for avoiding unnecessary debts. This way, you can save money you would have had to pay as interest. On the other hand, most importantly, you can pay for the sudden expenses if such an emergency occurs.

When You Have “Good Debts”

When carrying "good debts" like mortgages and student loans, you should consider saving up for an emergency fund rather than paying off the debt quickly. You can utilise these debts to help finance appreciating assets. It is more important to create an emergency fund than it is to pay extra money on good debts. You can save for your emergency fund by paying the minimum amount on your debts.

When You Have Used Your Emergency Fund or Do Not Have One Yet

Emergency funds keep you from taking high-interest debts when you need money for immediate expenses. For example, if your pet suddenly becomes sick and requires immediate surgery, you can pay from your savings if you have an emergency fund. These funds save you in times of distress. If you get laid off from your company, you will have a safe amount to pay for the monthly expenses.

No matter how many debts you carry, saving for an emergency fund for the inevitable situations is always a good idea. If you do not want to take more loans in such situations, you should always be financially prepared for the worst. Whenever there is a dilemma about emergency funds vs paying off debt, you must analyse your financial situation and decide between the two.

FAQs about Emergency Funds Vs Paying Off Debt

How to maintain an Emergency fund when you already have credit card debt?

Although it makes sense to pay off your "bad debts" like credit cards which carry higher interest rates, you will be drowned in more debts in immediate expenses if you do not save for emergency funds. In this case, you should pay a little more than the minimum on credit cards and save for an emergency fund.

Should I pay off my credit cards or build an emergency fund first?

Credit card debts carry higher interest rates, and you must pay compound interest for a long time if you continue paying the minimum amount each month. The best practice is to prioritise paying down significant debt while contributing small amounts to your emergency fund.

Which debt should I pay off first?

You should start paying off the small debts with the highest interest rates if you have multiple debts.

How does life insurance fit into clearing debt?

Life insurance ensures that your family isn’t financially burdened if something happens to you. If you pass away while still in debt, your family might struggle to pay off loans, but a good life insurance plan can cover outstanding loans and living expenses for your loved ones.

I have a home loan. Should I focus on repaying it or getting term insurance first?

Term insurance should be your priority. If something happens to you, the home loan will not disappear, and your family might have to bear the burden. A term plan can cover the home loan, ensuring they don’t lose the house.

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Disclaimer

This is an informative article provided on 'as is' basis for awareness purpose only and not intended as a professional advice. The content of the article is derived from various open sources across the Internet. Digit Life Insurance is not promoting or recommending any aspect in the article or its correctness. Please verify the information and your requirement before taking any decisions.
All the figures reflected in the article are for illustrative purposes. The premium for Coverage that one buys depends on various factors including customer requirements, eligibility, age, demography, insurance provider, product, coverage amount, term and other factors
Tax Benefits, if applicable depend on the Tax Regime opted by the individual and the applicable tax provision. Please consult your Tax consultant before making any decision.