Should You Save For An Emergency Or Pay Off Debt

If there is one thing the pandemic has taught us, it’s the need to save and prepare for emergencies. However, the money you set aside for emergencies could also be used to pay off your existing debts. Which should you prioritise? Paying off your debt or saving up for an emergency?

Feb 2022

3 mins read

Here’s how you can find an answer to this quandary:

1. Don’t entirely focus on one – try to balance both:

Most experts would advise you to balance your approach such that you optimise the situation with available funds. The general rule of thumb is to, “Pay off debt while also building your emergency savings.” If you decide to focus entirely on one thing without managing the other, it could create a bigger problem in the future.

For example, if you only choose to pay off your debt before you start saving, then, depending on the quantum of debt, it could eat into your finances for years, hampering your position in the event of an emergency.

On the other hand, if you focus entirely on creating emergency funds at the cost of letting your debts grow, the debt could balloon so much that you would have to dip into your emergency funds to clear it. Hence, finding a balance is the key to managing the situation efficiently.

In order to find this balance, you will have to answer three questions:

a. What are the interest rates on your debt?

Create a debt schedule to understand your debt and close off the debt with the highest interest rate first.

b. How much savings do you have?

You need an emergency corpus of about 6-12 months to take care of household expenses and other critical expenses. You can then route the excess funds every month to clear your debt over a short period. You can also use the money saved on EMIs to partially replenish your savings and pay off your other debt.

c. Do you have investments that yield lower returns than the interest on your debt?

If any of your investments have been performing poorly over the past few years, consider exiting them and using the proceeds to clear your debt.

2. Evaluate your circumstances carefully:

The pandemic years have been especially challenging. Many people have not only seen medical emergencies but also abrupt job losses, with devastating consequences in the absence of emergency funds. Some could also not avail of much-needed credit due to low credit scores.

It’s important to know your own situation well. If you already have high debt on your plate, any additional debt would be overwhelming. In any case, it’s imperative to have a basic emergency fund, to cover 6 to 12 months’ worth of household expenses and critical payments such as insurance premiums, tuition fees etc. This should be maintained in easily accessible/liquid investments, even if the returns are not attractive.

Similarly, it is important to evaluate your job security, income stability and support system when making a decision. Some of the key considerations are:

a. How secure is your job and how much emergency savings do you already have?

If you have a secure job, an emergency fund for about 3-6 months would suffice. If not, it is best to build an emergency fund for a period ranging between 6-24 months. The excess funds can then be used to reduce debts.

b. How stable is your income?

If you have a reasonably fixed income with mostly upward revisions and a consistent monthly cash flow, you can keep emergency funds for just 6 months. Otherwise, you may have to build funds for a longer period.

c. Can you avail credit from family or friends at no interest?

In India, the informal support system is quite robust, with family and friends lending a helping hand. If you have a strong financial support system and they are willing to help you during your bad times, you can consider having a smaller emergency fund.

3. Curb your lifestyle expenses and use the funds saved for debt closure:

Try to reduce expenses that can be temporarily postponed to relieve you of your debt burden. If you have been dining out frequently, you may consider eating out less often. Similarly, if you have been hiring a cab to go to the workplace, consider using public transport. Every rupee saved is a rupee earned.

The bottom line is that you cannot do one thing and completely ignore the other. The recommended approach is to use excess funds to retire high-interest debt, and then use the savings on EMIs to build an emergency fund.

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