After drinking too much coffee, I decided to throw the whole Twitter in disarray with a simple question: should I pay off debt or save for my emergency fund first?
As a heated debate, I have some opinions I want to share about both sides of the coin. I want to start with an analysis of debt and the emergency fund and then end off with some different scenarios and what would make sense.
I want to make it clear: there is no one-size-fits-all answer on this. But there might be some considerations on personal risk, insurance and the percentage of debt that you have.
Please don’t take this article as financial advice. This constitutes an informed and researched opinion.
The culture today encourages us to make loads of debt – and get a good credit record in return. If you don’t have a credit record, you’re not able to get a home loan, car loan or buy coffee.
Good vs bad debt
I know that I will get flack for this, but I believe that the only good debt that is acceptable is debt that you don’t have to pay for. For example, I own property with home loans. I have tenants that are paying off the loans with their rent.
The issue with debt is the bad debt – we buy things we cannot truly afford. Or we buy things we can afford on credit right now.
Then Interest rates go up.
Compound interest catches up on us.
Most people don’t understand the difference between good and bad debt. They use tomorrow’s money to pay for today’s luxuries – this is bad debt.
Factors influencing debt pay off decisions
I know that everyone wants to be debt-free. For many people, the burden of debt is like cholesterol to their finances – it kills their cash flow. It would make sense then that you want to get rid of the evil in your life before saving – especially in South Africa where the interest charged on loans is exorbitant.
It is recommended to list all your debts in a list like the table below. This will give you a good idea of what you’re dealing with.
|Amount owed||Interest Rate||Term||% of monthly expenses|
Debt repayment models
Magical people much more intelligent than me did some calculations and ways to pay off debt. Though I don’t want to go into them here, I do want to mention there are different methods to pay off your debt faster. All of them require you to pay in more than the minimum amounts.
- Avalanche method – paying off the highest interest rate first
- Snowball method – paying off the smallest amount first
Emergency fund considerations
With all your debt planned out, you also should know what your monthly expenses are. Remember to include annual expenses such as TV/car licenses! Depending on your risk level, you would need between 3 months and 1 year of emergency savings (see article here).
Consider how much you would need, and how long you would need to save to get your emergency fund in place. With your goals in place, it will give you a better idea of the ultimate goal you are striving to achieve.
We don’t have full control over everything that happens to us. Trying to quantify the risk involved can be complicated, as there are no concrete numbers, only estimations and probability. Consider the following scenarios:
- Death, disease or disability
- Interest rate hikes
- Car breakdown
- Outbreak fo the zombie apocalypse of the t-Veronica virus
- Market crash – all your investments disappear
- Babies – quintuplets!
These things could be devastating in your situation. In a black swan scenario (unforeseen, perfect storm and crazy coincidence), it is 100% possible that more than one of these things might happen all at the same time.
Remember, a 1929 crash of Wallstreet, a COVID-19 or you getting an overdose of tea* is 100% possible!
*Note that you cannot overdose on coffee. Coffee is life.
What about insurance?
Insurance is a necessary evil.
We need to have insurance.
Insurance might cover retrenchment, death, disability and dread disease. It might not cover your car breaking down, your (uninsured) laptop being stolen or an unexpected trip across the country to go to the funeral of a close and dear family member.
Why not pay off debt and save for an emergency fund at the same time?
If you want the best of both worlds, there might be different options for you to explore.
Have you considered saving your emergency fund in your credit card or home loan while repaying debt? For example, Mr Espresso has a R 100 000 credit card debt. He can pay any extra money into the credit card, and keep the account open in case of an emergency.
Mrs Latte, on the other hand, has a personal and car loan. She doesn’t have the ability to pay off more and withdraw the money later. In some scenarios, it would make sense to split repayments to debt and emergency fund.
There is no easy answer if you should repay debt or save for your emergency fund first. I do like the idea of saving your emergency fund in one of your debts that have a flexi facility such as a home loan or credit card – but that’s just me.
Once you are mindful of everything in your finances, you can start making decisions.
Don’t make decisions based on partial information.
Article reposted with permission from Frugal Local.