Emergency Fund vs Credit Card Debt

Which “first priority” should be your first priority?

If you have ever decided to begin taking your finances seriously, you might have heard some common advice about where to start. Typically, many good advisors will say you need to establish an emergency fund equal to 3-6 months worth of nondiscretionary expenses. This is the first step. Don’t worry about your investment goals right now, focus on getting an emergency fund established. Sounds reasonable, right?

However, in the same few breaths many of these advisors will also tell you to immediately pay off credit card debt. This is the first step. Don’t worry about your investment goals right now, focus on getting rid of burdensome high interest debt.

Not only can these goals seem confusing, but they can often come from the same advisor. Pulled together, the advice can sound something like, “First, establish emergency savings, but first you need to pay off your credit cards, but only after you establish some savings, once you pay off your credit cards.” They’re both important, they’re both critical, and you need to prioritize one over the other. Where to go from here?

I need to pause and mention one critical thing. Go read the first page in Principles of Prosperity. Follow that advice first. Without that, the rest of this doesn’t work. Nothing in your financial life will work. It’s a ten second read and (most importantly) free. Now back to the post.

So why would your advisor start you on your journey with two seemingly conflicting types of advice? Before answering, let’s tackle these ideas briefly and see why they are at the top of your money to-do list:

Establishing an emergency fund

This is your safety cushion, your financial buffer, your safety net. When you are suddenly faced with large unexpected expenses (and you will be faced with large unexpected expenses), this aptly named emergency fund is there to help you get by.

Common wisdom tells us to set aside 3-6 months of nondiscretionary expenses in this fund. For most people, one of the most difficult financial emergencies we face in life is sudden unexpected unemployment. In this scenario, your employment suddenly stops but your expenses do not. Of course you can stop going out to dinners and hold off buying new clothes in the meantime, but your fixed expenses (mortgage, rent, utilities, groceries, etc) keep going. That’s what nondiscretionary means: the fixed expenses that remain after eliminating all optional/discretionary expenses. Once you figure out these fixed expenses, simply multiply by 3-6 months and you have your target number for an emergency fund.

3-6 months is a common window to use, but your situation may vary. If you are very secure in your employment, three months should be fine. If you feel somewhat secure, but know getting laid-off is a remote possibility, then better to shoot for six months. If you are self employed in a cyclical environment or in a field of work where employment is less fluid, then you might want to consider an even longer time frame. Other factors include whether a spouse is working, other forms of income, the possibility of severance/early pension, or early social security if you are approaching early retirement age. All of these factors can help you find a number you are comfortable with, but do not fall below three months. Even if you have the most secure position possible the emergency fund is there for any unexpected large expense. Not just unemployment.

Note: make sure to stash this money away in a high yield savings account or money market. Chances are your local bank is paying you next to nothing for the use of your savings. Simply search for “high yield savings accounts” or “money market accounts” and make the move. Don’t worry, both types of accounts are FDIC insured up to $250,000.

Pay off credit card debt

According to Forbes, the average interest rate for credit cards is 27.81% (December 4th, 2023). While this can change over time, typically credit card issuers calculate an interest rate premium above and beyond the “prime rate.” In less technical terms that means “very high interest rate.” They’re expensive, they can ruin you financially, and are incredibly convenient and useful. It’s a perfect storm.

Just for an example, let’s say your TV breaks and are in need of a new replacement. You don’t have the money on hand to buy one today so you decide to wait rather than put the purchase on a credit card. However, Black Friday is next week and you see the TV you want on sale for $499. While you know your credit card will charge some interest, you decide it will be worth saving the $200 off the price of the television.

Once the first bill arrives, you decide to pay the minimums (since you saved so much money). On your $499 balance @ average 27.81% interest, your minimum payment due is $21.54. You begin making these payments and enjoying your TV in the meantime. 34 months later you see your TV is paid off, you’re still enjoying your purchase, and happy with the money you saved. Of course you know what I’m going to mention next. The tough truth is, once all payments are made, your TV worth $699 that you paid $499 for actually cost you over $740. That’s right, almost $250 paid in interest! To further illustrate my point, if you had waited to buy the TV, saved $21.54 a month in a money market (currently paying ~ 5.5%), you would have saved the same $499 within 23 months. Still a long time to wait, but much shorter than 34 months. And finally, once you combine all payments, investing towards your goal saves you $266 vs financing on your credit card.

That example illustrates why credit cards can be so dangerous. High interest rates, rolling debt, late fees, and possibly increasing rates. All of these characteristics are bad indeed but the real destructive power of credit cards is their convenience. They make it easy. You don’t feel the drain of high interest debt because the minimum payments are so small compared to the balance.

How to decide

By now you see the importance of an emergency fund as well as the dire need to reduce credit card debt. So where to begin? A well established emergency fund will make you feel less anxious about unknown costs, whereas eliminating credit card debt will dramatically improve your finances. Here are a few methods:

The “net worth first” method

If you have credit card debt but have plenty of room before you hit a limit, this might be the best choice for you. In this method, you attack credit card debt first and pay it off as soon as possible, regardless of your savings. The thought with this method is that it has the greatest impact on your overall financial health (net worth). With every payment reducing your balance, less interest accrues and the balance drops faster and faster each month. The drawback is you’re still left relatively exposed to an emergency. If you should suddenly face a large expense, you guessed it, it will likely end up on your credit card.

The “safety net” method

If the interest rates on your credit card are reasonable, perhaps this would work for you. In this approach, you will aggressively fund your emergency fund up to your target level. This method certainly “feels” better because there is nothing more useful, flexible, and fluid than cash. However, this is the least effective in improving your overall financial health. It is simply a strategy to help you sleep better at night. After all, when faced with an expense you will feel much less anxious paying out of cash savings you prepared in advance. One note: Credit card companies will sometimes comply to a request for an interest rate reduction. Make sure to call them and ask (can’t hurt!). Also, take advantage of 0% intro rates on transfers. Pay the minimum, don’t be late on any payments, and by all means, do NOT go further into debt!

The “Small net” method

This method might feel right for most individuals. This method is based on the idea that, while you might not face a very large expense frequently, smaller unexpected expenses do occur more often. In the small net method, you are able to “catch” those small expenses. You will begin by focusing on your emergency savings first. However, instead of the 3-6 month target mentioned above, you will aggressively save towards a much smaller amount. Say, maybe 1 month or $1,000. This is a great amount to help you pay for sudden medical deductibles, new tires, or a replacement computer. After your small net is established, you guessed it, time to hit those credit cards hard. If you do need to dip into that emergency fund, make sure to fill it back up before turning back towards your cards. And again, call your credit card company, ask for a rate reduction, and look for 0% promos!