You only have so much money.
So you may be struggling over whether it's better to save it for an emergency or pay off debt.
This decision can send some people into financial paralysis. They aren't sure what to do, so they don't fully commit to either choice.
But consider this: A Federal Reserve report on the economic well-being of U.S. households found that 40 percent of survey participants couldn’t cover a $400 emergency expense. To raise funds, people said they would have to sell something or borrow the money.
Here's a question on the savings vs. debt debate that I received recently from a reader during my weekly live online chat.
Q: I am pregnant with my first child. I moved in with a friend at the end of last year to save money and pay down debt. My timeline to move out has changed due to my pregnancy. I’ve been saving to pay off a 401(k) loan. I’m debating if I should pay off the loan or keep the money in my savings account, just in case, due to my impending new arrival. I will be out of work for four months of paid leave. But I will have to make those biweekly payments for the loan while I am out on maternity leave.
Thank goodness for the paid leave. Even so, the birth of a child can bust your budget more than you expect. I wouldn’t deplete the savings to pay off the 401(k) loan. Just keep making the payments out of the income you’ll receive while on leave.
It’s hard to see money just sitting there in the bank barely earning any interest. But your emergency pot is there for a purpose. You always need a rainy-day fund, because it always rains. It could be a drizzle or a severe downpour.
That is why every dollar of your earnings should have a destination. I try to get people to understand that their emergency savings isn’t growth money. It’s not like your retirement account, which needs to grow to keep pace with inflation. The mission of your rainy-day account is to keep you from having to sell stuff or borrow when you have an unexpected expense.
You have to have some savings even while digging yourself out of debt. If you don’t, and a crisis comes up, you’ll end up just going further into debt or bothering your friends and relatives for money. And trust me, I’ve heard from a lot of them. They are tired of you hitting them up.
So you are asking the wrong question when you ask if you should save or pay off debt. You should be asking: How much should I have in savings if I'm deep in debt?
To arrive at this figure, first consider your employment stability. Is your job secure?
If you aren't sure your job is safe, you'll need cash to help cover your expenses while you look for new employment. The debt matters, but a roof over your head and other life necessities become the priority. You may think you'll find another job quickly, but what if that doesn't happen?
Even if you’re confident that your job is protected (or as reasonably sure as any worker can be these days), put on hold any plans to save the recommended three to six months' worth of living expenses. You should definitely aim for this goal eventually, but not now. Instead, just save enough to cover the typical emergencies that frequently come up, such as a significant car repair.
A comfortable emergency fund for most people is probably between $1,000 and $1,500. Once you reach this goal, stop saving and use any extra money you get to attack the debt.
If your situation changes — such as if you have an unplanned pregnancy or there's a legitimate possibility of a layoff — slow down or put your aggressive debt-reduction plan on hold.
It’s good that the reader wants her 401(k) loan paid off as quickly as possible, but the pregnancy creates a higher financial priority for now. She has to have some “just-in-case” money.
What happens if there are complications and she needs to take leave without pay? What if a roommate with a baby was more than her friend bargained for and this new mother has to look for alternative housing?
The answer to your question of whether you should save or pay off debt is that you need to do both.