A question I often receive to Ask Nanci is, “I’ve just received a bonus/tax refund/lump sum, and I’m wondering if I should use it to pay off my debt or if I should start an emergency fund?”
There are two schools of thought on this issue:
- You should create an emergency fund of six months of expenses. If you don’t have an available emergency fund, and you have an unexpected expense (car repair, tax bill, home cost), you will need to borrow, and the cycle of debt will continue. Never saving and consistently borrowing for emergencies keeps you in a constant state of debt where you feel like you can never get ahead. Psychologically there is some truth to this.
- Mathematically (meaning, money in your pocket instead of someone else’s) it will almost never make sense to save before paying off debt. The reason is that virtually all lenders (banks, credit cards, loan sharks) charge a higher rate to lend money than they offer on deposits.In short, borrowing $10,000 is going to cost you ~6% or $600/year, whereas $10,000 in a high-interest savings account, is going to return .4% or $40/year. And so in this instance, it costs you $560/year just to maintain your emergency fund, and I don’t know about you, but $560 could cover at least one or two emergencies.
[clickToTweet tweet=”Mathematically, it will (almost) never make sense to save before paying off #debt.” quote=”Mathematically, it will (almost) never make sense to save before paying off #debt.” theme=”style5″]
There have been several times in my life that my debt outweighed my savings. And while logically I knew that if I received a $5,000 tax refund (because I contributed to my RRSP!) the smartest thing I could do was pay off debt, it bothered me when I did not have an emergency fund. I felt exposed.
But, and here’s the catch, it didn’t matter so much to me if the emergency fund had low funds (i.e. even just $500). I think the existence of an emergency fund, with enough for even just one small emergency, sends an energetic message to the Universe that having an emergency fund is important to you.
In my experience, signalling to the Universe what is important to me and then following up with action (i.e. adding even just $50/month auto debit) often results in the Universe co-creating with me on (in this case) my emergency fund growing.
So what’s my point?
Your priority should always be to pay off debt. But while you are diligently paying off debt (especially debt with an interest rate 10%), invest in yourself and send a message to the Universe by starting an emergency fund with even just $100 and $50 automatic monthly contribution.
If you are looking for a rule, a ratio of 90/10 debt-to-savings a good place to start. If you have debt, and you receive a lump sum of $5,000, put $4,500 on your debt (highest interest rate first), and $500 in your emergency fund. If you have a $400 monthly amount automated for your debt, change it to $360 debt and $40 emergency fund.
Trust me, when your debt is done and paid, it is going to feel amazing that your emergency fund is well on it’s way to being, well, an emergency fund.
And you never know—all those messages to the Universe on your financial responsibility could bring new money from where you least expect it. It has happened to me many times. Most of all, be nice to yourself—you are doing the best you can.
I recently had the absolute pleasure of speaking with Lindsay Plumb of Moola Financial Coaching in Victoria, BC. Lindsay tackles budgets (which makes all this debt and emergency fund stuff seem almost fun) differently from most coaches.
His and hers spending allowances?! Yes, please.
Here at The Money Coach, we focus primarily on getting you investing. But if you are looking for help with financial planning, budgeting, insurance, and stuff like that, don’t be shy to check out the good folks at Moola. (and no, that is not an affiliate link. The Money Coach is 100% independent)
Assumptions on the above post:
- None of the debt was tax deductible
- Savings was for emergency fund, meaning 100% safe high-interest savings account or GIC
Like what you just read here?
Subscribe and never miss a single post (it's free).