Rule of Thumb: Save for an Emergency or Pay Off Debt First?

You need to do both, but here’s how to prioritize

graphic showing two people on top of stack of books with a ruler and pencil. the words "financial rules of thumb" are in the middle

Joyce Chan / The Balance

It’s challenging to choose between saving for an emergency and paying off debt. If you’re having a difficult time deciding where to allocate the funds in your budget or from a windfall, you’re not alone. Household debt separate from housing costs skyrocketed to the highest level in 16 years in 2020, but at the same time, the household savings rate soared to levels not seen since 1975.

Is it better to pay off debt or save? Most people need to do both, but we’ll explore factors to consider when deciding which is the most important.  

Key Takeaways

  • Always pay at least your minimum debt payment and put something toward savings monthly, even if a small amount.
  • Individual circumstances can help determine priorities if deciding between two options. 
  • For long-term financial health, simultaneously establish habits around debt payoff and saving money.

What Is the Rule of Thumb About Emergency Savings vs. Debt Payoff?

The general rule of thumb is to do both: Pay off debt while building your emergency savings. 

“Saving at the expense of accelerating debt repayment ignores the importance of commitment to do both now,” he said. “It should never be an all-or-nothing option,” said Todd Christensen, education manager at Money Fit by DRS, a nonprofit debt management agency, in an email to The Balance. 

If you wait to pay off debt before saving for emergencies or even retirement, but then never manage to pay off the debt, one day you may realize it's time to retire and you are completely unprepared. And, perhaps, still in debt. 

That said, you could weight contributions toward your emergency savings—for a while, at least. Christensen suggested saving up a small nest egg—anywhere from $500 up to the amount of one month’s living expenses— if you don’t have anything put aside right now. But continue to pay more than the minimum on your debts. 

For example, suppose you have $100 in discretionary funds per month to put toward emergency savings, debt, or both. In this case, send an extra $5 or $10 to each debt account, and focus the rest on savings. 

"Discretionary" spending means the amount of money you can set aside each month beyond your living expenses. 

Take discretionary funds out of every paycheck right away, versus seeing what’s left at month’s end. “You never have money left over at the end of the month,” he said, meaning you’ve probably already spent it all. 

Establishing the savings mindset, rather than buying whatever you want every month, will benefit you long-term, he noted. You’ll be more likely to move the former debt payment into savings when you’re caught up on the account.

Samantha Gorelick, a certified financial planner (CFP) with Brunch & Budget, a financial planning firm, recommended a variation on that idea: Pay just the minimums on credit cards until you’ve built a solid savings cushion. 

Start with one month of expenses, she suggested, then try to accumulate a few months of savings. Starting small is fine—perhaps auto-deduct $10 to $20 from your paycheck and sending it to a savings account. 

"While it won't build quickly, you're creating a habit of saving—which makes you a saver," Gorelick said. As you get more comfortable with balancing spending and saving, increase the transfer amounts to savings.

If you stay invested for the long-term and keep making regular contributions, your money should at least see some growth and outpace inflation. Historically, until 2018 the stock market has returned around 10% a year on average. Plus, your money compounds in a tax-deferred investment account such as a 401(k) or IRA, so it can grow even more quickly. Missing out on one or two great years could make a big difference in your total savings.

If you are paying off the debt and simultaneously saving, you should end up on stronger footing than you otherwise would be.

How to Decide Whether to Prioritize Saving Money or Paying Off Debt

No one solution is right for everyone. But there are some questions you can ask to help you decide whether to prioritize paying off debt or socking away cash in a high-yield savings account. Ask yourself the following questions: 

What’s My Job Situation?

If you don’t feel secure in your job, prioritize emergency savings. That’s because if you aggressively pay down debt, then lose your job, you still don't have any money even if you have no debt, which leads to more card use, and added debt, Gorelick said. If you have savings, that can help prevent too much credit card use in the event of a layoff or shutdown. 

Christensen agreed, pointing out that having some savings gives you a little more breathing room when job hunting. “The worst thing that can happen when you lose your job and have no emergency savings is feeling like you have to find something, anything,” he said. “You end up in a lower-paying job. Later, when you try to get the type of job you had before, future employers wonder what happened when they look at your resume. It’s a tough situation to be in.” 

On the other hand, saving could be a no-brainer if your employer matches the contributions or a portion of the contributions that you make to your 401(k). With a 401(k) match you are getting an instant return on your money. Think of it as a bonus or a pay raise. It's easy money. So save at least up to the amount your employer will match, typically anywhere between 3% to 6% of your salary. An exception to the rule is if you plan on leaving your employer prior to being vested in those matching contributions.

How Much Do I Have in Emergency Savings? 

To determine how much you ultimately need in emergency savings, a general rule of thumb is to take your annual income and divide it by $10,000, Christensen said. The resulting figure is how many months of living expenses you’ll need in savings until you find your next job at equal pay. 

So, if you earn $30,000 per year, save up three months’ worth of living expenses. If you earn $60,000, you need six months’ worth.

If you find that you're drawing on savings every month—instead of contributing to it—revisit your budget, Gorelick suggested. Reduce your monthly contributions and focus on managing your expenses within your available income.

Do I Need Other Savings?

Christensen noted that “expected” expenses sometimes can be just as difficult as unexpected ones. For example, you’ll probably need to buy a car sometime in the next five to 10 years. But if you’re not saving for that car now, you’ll be at the mercy of the lender where interest rates are concerned.  Other “expected” expenses might include appliances or home repairs. Instead of having to draw on home equity to get a loan for those things, you could draw on a dedicated savings account for planned expenses. 

Make your savings hard to access—so you’re not tempted to be a “savings raider,” Christensen suggested. Stash cash in a bank that’s harder to access physically or online, separate from where you do your usual banking, for example. You want to be able to get to the money in a true emergency in a day or two, but not leave it vulnerable to splurging whims. 

What Type of Debt Do I Have?

Some debts have devastatingly high interest rates—such as payday, car title, and pawnshop loans, which can have an annual percentage rate (APR) well above 100%. If you have any of these, you’ll want to put as much as possible toward those kinds of debt, Christensen pointed out. Still, also put something into your emergency savings fund, even if it’s $1 or $2 each month. 

Other lower-interest debts, such as mortgage, car, and federal student loans, are still essential to pay regularly. But they may not be as pressing to pay down if you need to build your emergency fund. The higher the interest rate, the more you’ll benefit from getting the balance paid down quickly.

Due to the temporary pause on federal student loan repayment during the pandemic, you could take your monthly loan payment and put that toward emergency savings, Gorelick noted.  

Am I Expecting a Potential Windfall?

If you receive unexpected money from a government source, family member, or employer, spend it wisely. Christensen suggests the following formula as a rule of thumb for how to use that windfall if you’ve already got some savings: 

  • 30% for needs—e.g., replacing broken appliances or repairing your car, to prevent debt down the road
  • 25% for paying down debt
  • 20% for savings
  • 15% for long-term investment 
  • 10% for fun spending

However, if you have no emergency fund, consider this formula: 

  • 35% for emergency savings
  • 30% for needs
  • 25% for paying down debt
  • 10% for fun

Grain of Salt

Rules of thumb are general guidelines that might not work for everyone. You may need to take such rules with a grain of salt in your situation.

For example, if you’re behind on credit card, house, or car debt payments, catch up on those before building an emergency fund, Christensen stressed. Some unpaid loans, such as a car note, could cut off your access to work and other life necessities.  

But even in that situation, “If you can put just a dollar into your emergency fund, you’ve saved something. Being a saver is a lifetime choice, not a just choice until we’re out of the economic downturn. If more people saved, we’d probably never see another payday lender again. They wouldn’t be necessary.”  

If you're unsure, speak with a licensed financial professional or nonprofit credit counseling agency to get the best advice specific to your situation.