Paying Debt Off vs. Cash Reserves
Focusing only on paying off debt could leave you strapped for cash in emergencies, but saving for emergencies could leave you stuck with high-interest debts that take several years to pay off. There are different opinions on whether people should pay off debts first or build cash reserves for emergencies. You might consider an affordable option for handling both simultaneously instead of focusing on one while neglecting the other.
Other People Are Reading
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High Interest Rates
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Even financial advisers disagree on whether it’s best to pay off debts before building a cash reserve. Bankrate writer Marcia Passos Duffy notes that some advisers point out that people lose money by not paying off debts to hold cash in a savings account. That can happen because the interest rates for credit cards and other debts are usually several times higher than the interest earned on a savings account. Therefore, you could save more money each year by paying off high-interest debts that outpace the interest earned on the cash held in a savings account.
Economic Factors
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The potential for an unstable economy and high unemployment rates is why some advisers insist building a cash emergency fund should take precedence over paying off debts, according to Duffy. Some advisers recommend socking away cash to cover three to six months of living expenses in case you lose your job. Otherwise, you could face paying your debts with no cash reserve on hand while you're several months away from finding a new job.
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Affordability
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A more balanced financial-management approach may work best if you can’t afford to hold several months of living expenses in a savings account. Building a smaller cash emergency fund while paying a little extra on debts each month may be a suitable option for a tight budget. Besides, Duffy notes, people who focus on paying off debts without building even a small cash reserve would likely create more debts by using credit cards to pay emergency expenses. Consider setting a savings goal you can afford for your emergency fund and increasing your monthly payment on one debt at a time to save some cash while paying off your debts faster.
Considerations
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It may be less tempting to skip setting aside cash in a savings account each payday if you set up an automatic savings deposit with your bank. Many employers will deposit employees’ pay directly into their checking and savings accounts. One advantage of this is that employees usually can have a portion directly deposited into savings and have the rest go into their checking account. You may be less inclined to spend money you should save for emergencies if it never goes into your checking account.
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