How to build an emergency fund while paying down debt
Yes, you can do both at once. Use these tips to tackle the challenge.
Build an emergency fund? Or focus on paying off debt first? It’s a question many ask, and the answer isn’t always obvious—especially after a year like 2020. And while everyone’s situation is different, having $1,000 saved in your emergency fund to cover an unexpected expense can provide a significant boost to your peace of mind and mental well-being.
Ideally, your longer-term goal should be to save at least three months’ worth of living expenses in your emergency fund in the event of a serious life change or loss of income. However, if you have high-interest debt and are juggling multiple payments, saving even just $1,000 can seem difficult. And if you’re spending hundreds on interest every month, getting your debt paid down first may feel like a higher priority.
To help you figure it out, focus on your debt-payoff plan first.
Snowball: This approach is great for those who thrive on small wins. The idea is simple: Create a debt-payoff “snowball effect” by focusing on your smallest balances first. Focusing on the smallest balance is the quickest way to free up monthly cash flow—and when that balance is paid off, you can use the additional cash flow to make extra payments on your next-highest loan balance. This also gives you more flexibility to build emergency funds and cover unexpected expenses. Plus, it feels really good to see a balance paid off—even finishing off a smaller loan can give you a mental boost and the confidence to push forward. Cross it off your list. Breathe a sigh of relief. Then attack the debt with the next lowest amount. And so on.
Avalanche: If you’re into the “slow and steady wins the race” motto, this debt-payoff approach may be ideal. With this method, after making your minimum payments on all debts, you throw the rest of your money (whatever you can afford) at the debt that’s costing you the most in interest. Because the highest interest rate may not be the smallest balance, it may take longer to pay off, but you’ll spend less money over time as you typically pay less interest compared to the snowball approach. And when you do knock down that big balance, you’ll have some serious momentum—you may even feel compelled to shout, “Avalanche!” Keep in mind, since this method likely won’t free up cash flow as quickly as the snowball method, it may be trickier to build emergency funds if you take this route.
Debt consolidation: Applying for a new loan may be the farthest thing from your list of wants, but if you are struggling to pay off multiple loans or high-interest debt, or need to free up monthly cash flow so you can build emergency funds, debt consolidation can be an effective way to do so. Debt consolidation can happen various ways—for example, transferring balances to a new credit card is one form of debt consolidation, while taking out a personal loan is another. However, the idea is the same no matter what—you essentially use a new loan or line of credit to pay off as many existing debts as you can. Those loan balances are then combined into one new balance with a single interest rate, which could be lower than the interest rates on your current loans. In many situations, this can both reduce your monthly payments and save you money if you get a better interest rate.
Start small with your savings
As we witnessed with 2020, unexpected expenses or losses of income can happen without warning. And without an emergency fund, you risk increasing your debt even more. So once you feel confident about your debt-payoff approach, think about ways you can steadily build up your emergency fund.
Many financial advisors suggest starting small with saving. Set your initial emergency fund goal at $1,000, which is more achievable than saving three months’ worth of living expenses, but still gives you a safety net. If you’re able to stow away just $84 each month, you can get there in one year.
Simple saving strategies such as keeping your emergency fund separate from other accounts (and not touching it unless there’s a real emergency) and automatically depositing money into the account every time you’re paid can be effective, even if the deposits start small. Also, if you ever receive additional income, whether through a work bonus or a birthday gift, consider putting a portion of that extra money into your emergency fund to help it grow. Better yet, use another portion to make an extra payment on your debt—even a $20 payment can make a difference.
People are saving more now than they ever have,1 making today the perfect time to re-evaluate your budget. Are you driving less? Cooking more? Look at your finances through a fresh lens and plan your new opportunities for saving. Maybe there’s a subscription service you’re not using—the annual cost of many subscriptions could make a nice start to an emergency savings fund.
Create a budget—or adjust your current budget—with savings planned in. Then stick to the plan. Small, attainable goals outlined with a clear and realistic plan can lead to big wins, which gives you more financial confidence and better control of your well-being.
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