Young people in their 20s and 30s are at the very beginning of their money journey, and they get to decide what are the very first steps they take towards financial security. But when it comes to saving money or paying off debt, how do you know which way to go?
Ideally, you should be working towards both saving and paying off debt, not one or the other. However, not everyone has unlimited cash flow to meet all their financial goals at once, so they have to make decisions about where to focus their efforts.
Should I save or pay off debt?
Save! Save money! Save more money than you think you need before you focus on any other financial goal.
Having an Emergency Fund is the single most important part of your financial plan after earning an income. It’s more important than getting to debt-free. It’s more important than starting your retirement savings accounts. It’s more important than saving a down-payment for a home.
You need an Emergency Fund more than you need anything else!
How much money should you have in an emergency fund?
You should have at least $10,000 in your Emergency Fund, with the ultimate goal to bring it to a $25,000 to $50,000 balance depending on your family size and other financial assets.
I used to think $5,000 was more than enough
I used to tell people to try to save a $3,000 Emergency Fund if they were single, and $5,000 if they were part of a couple or had children, and then focus the rest of their efforts on debt repayment.
That amount isn’t the typical 6-12 months of savings most financial gurus suggest you have on hand. It’s a sum that’s easier and more accessible to young people still trying to get a foothold in financial security. For most 20-somethings, it’s enough to pay a few months rent and buy groceries. And who would ever need more than a few months?
Obviously, I gave this advice imagining the worst-case scenario was a layoff. I never pictured a pandemic world where most people would lose their jobs, the stock market would tank, childcare centers would close, and there wouldn’t even be options to earn extra income.
I never knew it could get this bad, and maybe you didn’t either.
Now I’d like to publicly re-state my new perspective: you should never have less than $10,000 in your Emergency Fund.
Furthermore, your target balance in your Emergency Fund should be at least $25,000 and up to $50,000 if you have children. If these numbers are giving you a headache, I want to acknowledge that it takes years to build a solid Emergency Fund.
You might be able to lock down that first $10,000 in one or two years, but a $25,000 balance is definitely a 5-year plan. And that’s ok. You’re not in a race against anyone. You’re doing this for yourself.
You need a cash cushion more than you need to be debt-free
Most people struggle between paying off debt and saving because both are noble goals in the pursuit of financial security. But one is better than the other, and it’s having cash on hand.
You can always pay your credit card bill with your Emergency Fund, but you can’t save an Emergency Fund on credit
If you’re carrying around any credit card debt, your minimum monthly payment is likely equal to approximately 3% of the total balance you owe. So if you have a $3,000 balance, you need to pay at least $90 towards it each month.
Imagine you have $2,000. You can keep this as an Emergency Fund, or you can dump it all on your credit card debt and lower it to $1,000. The latter choice is great… as long as you don’t face an emergency.
If you use your savings to pay off debt, you’ll be debt free. But you’ll also be without a cash cushion for unexpected expenses, and exceptionally vulnerable to expenses that cannot be charged to a credit card.
But what about interest?
It’s true it might seem mad to keep $1,000 in a savings account earning 1.5% interest when you have $1,000 in credit card debt costing you 19.99% per year. But peace of mind and flexibility have value, too, even if you can’t work it out in dollars and cents.
It was actually a financial advisor a few years ago that told me some of the wisest words I’ve ever heard:
Your money doesn’t have to be earning the highest return to be working for you.
Sometimes your money is giving you something more than interest income. It’s giving you peace.
This doesn’t mean paying off debt takes a back seat!
Even if saving a cash cushion to protect you against the worst will take priority, you shouldn’t (and really can’t) neglect your debt entirely.
You still need a workable debt repayment strategy even if your savings is taking priority. Continue to make payments on your debt even as you build up your Emergency Fund or retirement savings accounts.
Now if keeping cash in savings when it could be used to pay off debt is making you anxious, then it’s not buying you the peace of mind it’s supposed to. Personal finance is personal, and only you know the right balance for yourself of cash to debt when going into a crisis.