Emergency Savings vs. Debt Repayment

“A bank is a place that will lend you money if you can prove that you don’t need it. – Bob Hope

Common sense reader mailbag: I have am building up my emergency savings fund but I’m sick of seeing such small returns with interest rates set so low. And I don’t know how much I really need in there.  I only earn 0.75% in my online savings account. I also have a home equity line of credit (HELOC) that has an interest rate of 5.50%. Should I cut back on funding my emergency savings account to pay down this debt?

A standard personal finance rule of thumb says that you should have at least 6 months of expenses saved up in your emergency savings fund. Unfortunately for most people this can be next to impossible to put into practice without seriously jeopardizing other important goals.

You must also worry about saving for retirement, debt payments, possibly college tuition for your children, vacations and your current budgetary needs. It can be difficult to prioritize these goals and figure out which ones are the most important for your situation.

This is an interesting problem, especially with the large difference in interest rates.

The way that banks make their money (in addition to the fees they charge their customers) is through the spread they earn between the money they lend to customers and the money they borrow. This usually involves borrowing short-term (your deposits) and lending long-term (mortgages, car loans, etc.).

With short-term interest rates basically set to zero by the Federal Reserve it is very difficult to find a safe vehicle where you can earn a decent interest rate on your savings. And the banks are taking advantage of the situation by borrowing from you, their customers, at close to 0% and lending out at a much higher rate (in this case over 5%).

This is a situation where you should be able to take the 6 month rule of thumb for your emergency fund and cut it down to a more manageable level to make sure you have enough to cover unexpected expenses while still knocking down those annoying debt payments.

Most “emergencies” that we fund from savings are actually events that we should be able to plan ahead for anyways. You should expect to pay $500 to $1,000 a year in car maintenance costs (the average is about $0.05 per mile each year). This could be much more with an older car. Maintaining your home can also eat into your budget when things periodically go wrong. Healthcare costs are also a good one to prepare for in advance.

You should be setting aside cash on a monthly basis to cover these expenses so you don’t have to draw down your emergency fund to pay for them. Think of this as a hedge against your transportation, home and health. The months you don’t use the cash you can stow it away and wait until you ultimately have to pay for these issues.

Avoiding the impulse to tap into your emergency fund for these expenses and instead waiting for actual emergencies will make it easier to keep a more reasonable 2 to 3 months of expenses in your savings account. Once you get to that level and have a comfortable backstop I think it makes sense to use your extra cash flow to pay down your higher interest debt. You are assuring yourself a 5.50% return on your investment by making these extra payments. The same logic applies to credit card debt and the rates on those are much higher.

You can think of this as a way to increase the yield on your savings account and or even as a bond fund substitute. The 10 year treasury is currently yielding about 1.70%. This could be a solid strategy for someone that has a low tolerance for risk and is concerned about investing in stocks.

If a situation should arise that requires you to tap into your emergency fund you can always reduce the extra amount that you are using to pay down your home equity loan.

Another bonus in this situation is that you are actually increasing your line of credit by paying down the HELOC early. As long as you are disciplined and don’t tap this credit to remodel your kitchen or bathroom you can use the HELOC as another emergency backstop in a tight spot.

Additionally, think of this as a great way to get back at the too big to fail banks that took all of your taxpayer bailout money. They don’t get to earn that spread on your funds anymore and you can use them if you need your own personal bailout by tapping your line of credit.

How would you handle this situation? Build up your emergency fund or pay off the high interest rate debt?


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  1. Paul @ The Frugal Toad commented on Apr 22

    I agree with you Ben on establishing a minimum 3 month emergency fund before paying down debt. It may also be necessary to take on a second job to pay down the debt.

    • Ben commented on Apr 22

      Right. The other option is to split the difference and fund both goals at once. You won’t hit your targets (pay off debt or build up savings) as fast but you will see some progress on both fronts and hopefully that keeps you motivated to stick with it.

  2. Brian commented on Apr 23

    Pay off the HELOC. But I am in the camp that thinks a 3 – 6 month emergency fund is a waste because you are losing money to inflation and it is even worse when you are allowing interest to pile up (ie credit cards). The math just doesn’t make sense. But hey, if a 3 – 6 month emergency fund helps you sleep better at night, so be it because I am also in the camp that you have to do what makes you feel comfortable.

    • Ben commented on Apr 23

      I agree. For most people it is also just unrealistic to have an emergency fund of that size. You should have enough set aside to pay for periodic expenses, like I outlined, but there is no need for overkill. Credit cards are an even easier decision than the HELOC. Pay them off before building up your emergency savings. Once paid off, use those funds to build up a small backstop. Then transition that payment into retirement/investment savings.

  3. You Can Lose Money in Cash - A Wealth of Common Sense commented on Jul 11

    […] You also need cash when you have near-term spending needs. In fact, I would urge you to keep enough in your savings account to cover a few months’ worth of expenses in the case of an emergency. […]