Is It Better to Pay Off Low Interest Debt or Save an Emergency Fund?
I have finally arrived at a fork in the trail after a grueling trek up the mountain. My wife and I have paid off around $83,000 in debt in 16 months. We are now left with roughly $24,000 in non-mortgage debt that consists of the below.
If you want to see where we came from and how we got there, then be sure to check out: How Do I Escape the Middle Class Trap and Become Financially Secure?
| Debt (Interest Rate) | Total Amount | Minimum Monthly Payment |
|---|---|---|
| 401K Loan #3 (3.5%) | $3,510.11 | $90.96 |
| 401K Loan #2 (3.25%) | $5,865.09 | $180.80 |
| 401K Loan #1 (3.25%) | $6,520.31 | $180.80 |
| AC/Furnace (0%) | $7,896.70 | $358.95 |
| Total | $23,792.21 | $811.51 |
We now face a question that a lot of people ask themselves during their financial journey. Should we prioritize paying off our remaining non-mortgage debt, or building a strong (i.e., 3+ months of living expenses) emergency fund? The correct answer is “building a strong emergency fund”, but let’s talk about how we got to this decision.
What Do the “Experts” Say?
When it comes to thinking of a person with a complete blind hatred for debt, it’s hard to think of anyone that carries more hatred than Dave Ramsey. If you are unfamiliar with him, Dave Ramsey is a very popular financial personality that encourages people to establish strong financial positions and live debt free. In order to accomplish these goals, he published Dave Ramsey’s 7 Baby Steps. These steps are intended to make the road to financial peace a little less intimidating.
While Dave’s roadmap to financial peace consists of 7 steps, we’re only going to focus on steps 2 and 3 today because they focus on paying off non-mortgage debt and building a strong emergency fund.
- Baby Step 2: Pay off all debt (except the house) using the debt snowball
- Baby Step 3: Save 3–6 months of expenses in a fully funded emergency fund
If you are blindly set on being debt free as quickly as possible, then sure, follow these steps. But if you want to be practical, then you’ll want to modify these steps. These steps assume that all non-mortgage debt is equal, but that’s just not the case.
If you have credit card debt that is burying you in 22% interest, then by all means, prioritize paying this debt off before you build up a strong emergency fund. However, if you have some debt that is 0% interest and you aren’t struggling to make the monthly minimum payments, then it would be silly to pay this debt off before your build a strong emergency fund. Why? Let’s look at what common sense says.
What Does Common Sense Say?
If you are trying to decide between paying off low interest debt or building an emergency fund, ask yourself the following question:
- What is my biggest financial risk right now?
At the time of writing this post, my answer is easy. It’s my lack of an emergency fund. How do I know this? I thought about two specific scenarios that would meet the criteria of a financial hardship. Then I thought about what I would rather have in each scenario.
- If I lose my job tomorrow, what would I rather have: an emergency fund or no low-interest debt?
- If I need to pay for a major, unexpected expense tomorrow, what would I rather have: an emergency fund or no low-interest debt?
The answer to both questions is obvious to me. I would rather have an emergency fund. Let’s consider the below scenarios.
- If I have some low-interest debt and an emergency fund, and I:
- lose my job, then I can provide for my family without taking on more debt.
- need to pay for a major, unexpected expense, then I can (hopefully) pay for that expense using my emergency fund, which prevents my family from taking on more debt.
- If I have no low-interest debt and no emergency fund, and I:
- lose my job, then I will not be able to provide for my family or will be forced to take on new (likely higher interest) debt to provide for my family.
- need to pay for a major, unexpected expense, then I will be forced to take on new (likely higher interest) debt to pay for the expense.
But What About the 401K Loans?
One additional factor that I need to take into account is the fact that some of my low-interest loans are 401k loans. Money that is borrowed through a 401k loan is not invested while the loan is outstanding. This means that if the stock market goes up, then my money is not invested during that time and I miss out on those gains. However, the flip side is that if the stock market goes down, then my money is not invested and I miss out on those losses.
I may not be Warren Buffet, but I know that trying to time the market is a fool’s errand. While I would rather have this money invested in the stock market as soon as possible (since time in the market beats timing the market), I still know the smarter decision is to prioritize building an emergency fund. My family’s financial risk is much higher without an emergency fund than temporarily not having some money invested in my 401k.
Why Can’t I Do Both at the Same Time?
Some people may be asking this question – Why does it have to be one or the other? The reality is, it doesn’t. I could absolutely focus 50% of my monthly surplus money towards my debt while contributing the other 50% towards my emergency fund. Maybe that’s something I’ll eventually do, but not yet.
Right now, I have an emergency fund that consists of one month of living expenses. While this is something to be proud of (because it is far better than where I came from), it is still too small for my comfort. If we have a medium-sized financial hardship come our way, then our emergency fund will be depleted and we’ll be left financially exposed to whatever else may come our way.
We would not be able to cover a big financial hardship, or even back-to-back small/medium sized hardships without taking on debt. Maybe once our emergency fund is built to 3 months of living expenses I will be comfortable starting to divert some monthly surplus money away from emergency savings and towards our low interest debt.
Conclusion
To sum up the above section – In the event of a financial hardship…
- An emergency fund gives me options, while no low-interest debt limits my options
- I am more likely to take on debt if I don’t have a strong emergency fund
- I am more likely to miss mortgage payments if I don’t have a strong emergency fund
While your situation may not be as black and white as mine, I hope that thinking through some of these scenarios and questions makes the answer for your personal situation a little more obvious.
