Oct 28 2008

Bulk up savings account, or pay off debt?

A story in today’s Post-Gazette questions a common question in personal finance: Should you add money to savings or pay off debt?

Of course, the answer is “it depends.”

If you follow Dave Ramsey’s advice, you know that he recommends putting together $1,000 as your starter emergency fund before paying extra on anything — no extra debt payments to your credit cards, cars, or house.

If you suddenly need $1,000 in cash and you don’t have it (say you lost your job or had an emergency pop up) you could risk losing your assets.

If you don’t have even a modest emergency fund, one insurance claim, one appliance breaking, or one emergency trip could send you over the edge. If you have a lot of debt on your credit cards, you might not be able to charge your way out of an emergency. Some credit card companies have recently lowered people’s credit limits. And if you’re already maxed out, then you’re out of wiggle room entirely.

That’s why I think it’s essential for people to have a small emergency fund in place first.

Yes, it’s true that you might only earn 2 to 3 percent interest on the amount, and that can be frustrating if you’re paying 15 to 20 percent (or more) on debt. An emergency fund is not intended to build your wealth. It’s to protect you from financial disaster.

So park your emergency fund in a savings / money market account where you can draw a few percentage points on the balance. Right now, ING Direct is offering 2.75 % APY, I think. A month or so ago, I moved my emergency fund from there to my other bank because it was offering a 4 percent interest rate good for six months.

OK — now that we’ve got that emergency fund going, what do we do next?

Evaluate your personal situation. If you’re living on one income, you might want to have a larger emergency fund before tackling your debt full-force. Or, you might want to put 60 % of your extra money into savings and 40 % toward debt, or some other combination. Do what feels comfortable for you and your situation. The important thing is that you’re making progress.

Say you owe $300 on a credit card. If you can pay that off this month, do it! The fewer bills you have, the better your financial situation is. That’s one payment you’ve just permanently eliminated — one minimum payment you no longer have to deal with.

But, if you think your job is in serious jeopardy, you might want to put that $300 into savings for now.

Right now, we have our six-month emergency fund in place and we’re working on paying off our car early. Because we’re going to have a baby in a few months, we want to be a tad bit conservative with our debt repayment efforts for the time being.

We want to make sure we keep putting money in savings — not our emergency fund, but savings for baby-related things and other upcoming expected expenses. Once those needs are met, we’re sending extra funds to our car.

The point is, everyone’s situation is different, and people’s circumstances can change at a moment’s notice.

What do you do?



3 Responses to “Bulk up savings account, or pay off debt?”

  1. Although we had outstanding student loans, we chose to build up a 3-month emergency fund and save for a down payment for a house in our first year of marriage- those were our priorities. This summer, we saw the student loan debt totals going down, & decided to pull a “Dave Ramsey” and entirely pay off the student loans, with only the $1000 emergency fund left in the bank. Now we’re working to save up a more substantial emergency fund and save for FUN stuff, because we’re debt free (besides the mortgage)!

    As you said, it’s a personal decision based on your risk-tolerance, aversion to debt, life stage, and priorities. We made the right decision for us, but it’s not for everyone.

    joanna’s last blog post..Thought for the day

  2. I enjoyed that article you linked. It always amuses me to see how others save/pay off debt. I think we’ve got enough saved in our emergency fund, but I’m going to pad it even more! :)

    MrsMoney’s last blog post..Tasty Tuesday! Baked Spaghetti Squash Ratatouille

  3. i had built up my $1500 emergency fund, and then switched to debt focus. then when i got my part time job and realized how LITTLE i would be bringing home, i switched again back to focus on savings, trying to get the emergency fund built up even more in case we really need the money down the road (if hours get cut or whatnot). so now i’m putting a set amount into savings each month and sending some snowflake money towards debt if we have it. it’s frustrating because it’s moving sooooo slowly, but i know it takes time.

    tiffanie’s last blog post..hectic schedule makes for lazy blogging!

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Hey! I'm Kacie, wife to Shane and mother to Jonathan (7), Vivienne (5) and Amelia (2) . I write about my family's finance: how we save money, improve our spending, and plan for the future.

I hope I can inspire and encourage you to improve your situation. See disclosure.

I'm adopting a much slower-paced posting schedule, and treating this as a hobby blog now.

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