Save an emergency fund first, or pay off debts first?
The next chapter explains what an emergency fund is, where to save it and how large it should be. It is essentially a rainy-day fund, and you definitely need one for financial freedom.
But you also need to rapidly pay off your debts in order to reach financial freedom, as will be explained in the chapter after that. Which of these should you do first?
Here is the order of operations:
1. If you have debt other than a mortgage, first save up a small emergency fund. This should be enough to cover your expenses for about three months. For example, if you live on $2,000 a month then you’ll need to save up an initial emergency fund of $6,000.
[During this time you must continue to meet minimum repayments, of course.]
2. Start aggressively paying off your debts, one by one in the order explained in Step 4: Get Out of Debt. Do not cut into your emergency fund to do this. That fund is, as the name suggests, only for emergencies, and you’ll need to top it back up every time there is an actual emergency like car repairs or a medical bill.
3. Once all debts are completely paid off, not including a mortgage if applicable, start enlarging your emergency fund to make it as generous as I will recommend in Step 3 (sneak peek: enough for six months to a year of expenses).
[Edit: after the craziness of 2020 I reckon the second edition will revise this to 6 months – 2 years.]
4. Once you are debt-free and have a 6-12 month emergency fund saved, further savings should go into your investments as described in detail in Step 8: Invest Wisely. House payments might be included as an investment. Remember, no money from your emergency fund is to go into investments. That money stays right where it is and immediately gets topped up with income earmarked for investment if it is ever depleted.
The rationale: you need an emergency fund regardless of your situation, hence it is the highest priority. Debt comes next because debts cost you money the longer you have them. Third comes increasing the emergency fund because having only three months of expenses saved is living on the edge and you don’t want to do that for any longer than necessary. Last is investing because you generally can’t make long-term investments until you’re out of debt and have a good emergency fund set up.
A note for homeowners or those planning to be one: sometimes it can make sense to make long-term share market investments [etc.] even while you are paying off a mortgage, depending on various circumstances. This is probably more advanced than my readers are ready for so I will not get into the details, but hit the links at the endnotes for further information.[i] [ii]
This order of priorities is convoluted but important. Consider bookmarking this page and referring back to it as we reach the chapters on saving an emergency fund, paying off debt and investing.
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