Managing your money wisely is essential for ensuring long-term financial health. One important aspect of money management is prioritising the creation of an emergency fund before focusing on paying off debt. Let’s explore why this approach is crucial.
Imagine having €20K of debt and no savings. In this situation, it’s wise to prioritise building an emergency fund. By focusing on saving first and making additional debt payments only when possible, you can protect your long-term financial well-being. This approach prevents unexpected expenses from exacerbating your financial troubles down the line.
The core of your personal financial plan should be centred around building an Emergency Fund. Aim to have three to six months’ worth of savings set aside, or even more if you feel comfortable. While there are no hard and fast rules about the exact amount, it’s crucial to start building this fund promptly.
Coping with unpredictable events
Life is full of unpredictable events. Take the COVID-19 pandemic, for instance, which demonstrated how unforeseen circumstances can have a significant impact on our lives and finances. An emergency fund is designed to handle such emergencies and provide a safety net during challenging times.
To start building your Emergency Fund, allocate an extra amount of money each month towards savings. Even saving €100 per month can add up to €1200 by the end of the year, which could cover a month’s worth of expenses for many people. As you save consistently, you’ll build momentum, gradually working towards your goal of having a three month fund ready to handle unexpected situations.
Why debt repayment is the secondary priority
One common challenge people face is not having enough money left to save at the end of the month. This is where the principle of ‘pay yourself first’ comes into play. While you can’t avoid paying your debts, such as home loans, car loans, student loans, or credit card debt, you can focus on paying the minimum required amount on your debts each month. Instead of putting extra money towards debt repayment, divert those funds to your emergency fund.
Identify what is referred to as the ‘latte factor’, which refers to small routine expenses that can be eliminated to have a significant impact on your finances. By cutting out these unnecessary expenses, you can free up more money to put towards savings.
Paying off debt first may seem tempting, but it can hinder your Emergency Fund. Unexpected expenses can arise and take priority over debt repayment. Health issues, children’s needs, or essential household replacements may require immediate attention. It’s crucial to ensure these expenses are taken care of before allocating extra funds towards debt repayment.
Building your emergency fund should be your initial focus because it provides a sense of security when unexpected situations arise. Unlike debt, which can be gradually paid off, one-time costs demand immediate attention. By having reserves in place, you’ll be better equipped to handle emergencies without derailing your financial progress.
Luca Caruana is the founder of the Money Coaching Hub. Follow his weekly column here and his LinkedIn account or his Instagram for more budgeting hacks. For other money-related columns, check out Luca’s tips for children’s pocket money, and his tips on how to actually build an emergency fund.