Debt Reduction Plan: How to Create an Emergency Fund? Should You Pay Down Debts or Create Emergency Fund?

I’ve read the reports where the experts say you should have cash for 3 months worth of bills set aside in an emergency fund. Some of these experts say you should save even more than that. Chase Bank, for example, says your emergency fund should have somewhere between 3 and 6 months of living expenses. 

If you are living in debt, however, could that money be better utilized in other areas of your finances? What if you send the money in your emergency fund to pay down your highest interest debt? What if you have an emergency after doing so?

Emergency Fund - Table of Contents

What is an Emergency Fund?

An emergency fund is a safety net of money. It should be easy to access in case of an urgent financial situation, i.e. an emergency. 

Having an emergency fund is a core part of being financially healthy, so that you can help protect yourself from natural financial ups and downs. You don't want to fall into a deep hole of debt because you were financially unprepared for an emergency.

How much money should you have in an emergency fund?

Your emergency fund should have between 3 and 6 months of living expenses. This doesn’t mean 3 to 6 months of your salary. This is 3-6 months of living expenses. How much it would cost you to get by for that length of time? 

How to calculate living expenses? Include expenses like rent, utilities, debts, and food. Don’t take into account non-essential luxuries that you'll be able to eliminate if needed, such as entertainment and dining out. 

Here are some more questions that might be helpful to ask yourself:

• Have I budgeted for my whole family? Nuclear or extended family, depending on who relies on you? How will my family’s financial needs change down the road?
• Is my career path or industry particularly risky?
• How much does my income fluctuate every month?
• Could there be times when I make less than I do right now?

Something is better than nothing. If you don’t think you can hit the recommended target of 3 to 6 months of savings, do what you can. Start saving in small amounts every month, and soon you’ll have a nice cushion.

Where to Keep Your Emergency Fund?

To begin, your emergency fund should be placed in a high interest online savings account and getting no less than a 4% return. 

While many may have their current emergency fund in a low-paying brick and mortar bank or even in cash sitting at their home, this is a waste since you are losing on easy to get interest.

Access is key. Long-term accounts such as CDs may not be a good fit. An FDIC-insured savings account is a great place to keep emergency funds, but do your research and pick an account that suits your needs.

Should You Create an Emergency Fund OR Pay Down Your Debts?

It has already been discussed how you can take your savings and use them to reduce your debt (by paying off the lowest interest debt first or by paying off the smallest debt first -- the aptly-named Snowball Debt Reduction Method), but should you take this one step further and include your emergency fund in this debt reduction process as well?

If you use your emergency fund to reduce current debt, that money would obviously save your more in interest paid than what you will make from placing the money in savings account, even if it is a high interest online account. 

A Credit-Base Emergency Fund?

While this is easy to see, it’s still difficult to give up that emergency fund because what if you have an actual emergency and need that money. The answer to this question is simple – you just cleared that much money in available funds from your credit, didn’t you?

Although you hope it won’t happen, if your refrigerator stops working or you need to repair your car, you can put that money back on the credit card that you paid down. Doing this would still keep you financially ahead because you already saved the interest payments on that money when you sent it in the first place. In essence, you are now using you credit card as your emergency fund instead of cash.

You are much less likely to use that credit card for anything unless it truly is an emergency and a lot of people delve into their emergency funds a little here and there for things that they should not. This will make it easier to stop making that mistake and will save you in interest paid as you work your way out of debt.

Debt vs. Emergency Fund: Final Thoughts

Everyone wants to have a savings account at some point and an emergency fund to guard against unfortunate occurrences in our lives, but if you are living in debt, that debt, as well as the interest it accrues is your current emergency.