Pay Down Debt or Build Up Emergency Fund?

by James & Miel on March 29, 2009 · 0 comments

Hi All,

Being a personal finance aficionado is a bit like being a reformed alcoholic. A lot of people “hit rock bottom” before they really get interested in cleaning up their financial act.

So, if you’ve “hit rock bottom” and found the motivation to clean up your act, you might be wondering if you should pay down your debt or build up some emergency cash?

The answer is: do both.

Lets assume that you have, say, $15,000 spread out over various kinds of obligations. This might include, a bank overdraft account at 20%, maybe a couple of credit cards at 13% to 20%, a car loan at 6%, etc etc.

The thing to do in this scenario is sort your debts by how much you owe and your rate of interest on the debt. Next, figure out which of the debts which has the highest interest rate, and pay off like $1,000 of it. Then, consider socking away $500 to $1,000 to build up your emergency fund. Put this in a high yield money market account. After that, attack the rest of your debt. Knocking down that debt will allow you to start saving more, but putting money into an emergency fund gives you some security to fall back on.

People say you should pay off your highest interest rates first, but its more important that you come up with a system that works for your personal and cognitive style. For example if you need more rewards throughout the processes, its okay to pay off lower interest rate, lower balance debt if helps you stay motivated. Right so if you have an overdraft account that you owe $500 dollars on, but it carries less interest than your credit card, you could always pay that off $500 to get an early psychological win. Its true that paying off your highest interest rate debt is the most mathematically efficient way to dump the liability, but it does nothing for you if you are not psyched about the processes.

Paying off debt is a major drag. I had over $15,000 in credit cards at one point, and its not fun.

Good luck!

James

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