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?