Build an emergency fund or pay down debt? A financial advisor weighs in.
Financial advisors often recommend clients build an emergency fund and use it only in true emergencies. But what about when you spend hundreds of dollars each month to pay down high-interest debt – is that an emergency?
Financial advisors often recommend clients build an emergency fund and use it only in true emergencies. But what about when you spend hundreds of dollars each month to pay down high-interest debt — is that an emergency? And should you dip into that fund in order to decrease your debt burden?
Which should consumers prioritize: paying down debt or building an emergency fund?
The consumer should build an emergency fund before paying down debt. There are some important factors to consider when implementing that plan, however.
Consumers first need to define an emergency for their individual or family circumstances. Simply put, the scope of feasible emergencies may differ if children or pets are in the picture, for those who are business owners, and depending on whether consumers rent or own property, as well as the elasticity of demand for their employment — that is, their job security — among other factors. Then they need to do their best to quantify these risks and come up with a plan to build the necessary reserve.
They also need to identify why they hold high interest debt in the first place: Was it an unavoidable expense they had to put on a credit card? Was it spendthrift tendencies? If avoidable behavior is the reason for the debt, they need to correct it, or the debt could continue to balloon.
After understanding the cause of the debt and determining the requirement for an emergency reserve, consumers should aggressively pursue building the reserve before making debt payments over the minimum.
Should people tap their existing emergency funds to pay down high-interest debt?
In short, no. The fund needs to remain intact in case of an emergency. However, if the financial estimate of what constitutes an “emergency” has decreased, then perhaps a consumer could justify depleting the reserve by a small amount.
But instead of using an emergency fund, I’d recommend debt-swapping to pay off the debt. As an example, most high-interest debt isn’t deductible, but mortgage or home equity line of credit debt typically is, and has a lower interest rate. Thus, if an individual has an equity position in their home and is eligible for a HELOC, he or she might be able to swap debts.
In general, anytime the individual can substitute debt for another with a lower interest rate without incurring additional fees or an increase in principal balance, they should consider doing it.
In what other cases, if any, might emergency funds be used for nonemergencies?
Emergency means emergency. Individuals need to be honest with themselves about what an emergency really is. Rationalization of nonemergency expenses is the road to financial destruction.
This story originally appeared on NerdWallet.