TL;DR version: Skip the emergency fund until your credit cards are paid off, then build up an emergency fund before attacking lower-rate debt.
Long-winded version:
If your credit cards aren't maxed out, I would suggest you just use those as your "emergency" fund. Credit card interest rates are so ridiculous that you're throwing so much money away by not paying them off as fast as humanly possible.
Let's look at a couple of examples. For all of these scenarios, you start with $10k in credit card debt with 15% interest, your savings account pays 0%, and you have $500 per month to allocate between the credit card debt and building up an emergency fund.
Scenario 1 - pay $250/month toward debt until it's gone, save the rest in emergency fund, no emergency happens:
Year | Credit card balance | Emergency fund balance | |
0 | $10,000 | $0 | |
1 | $8,392 | $3,000 | |
2 | $6,526 | $6,000 | |
3 | $4,360 | $9,000 | |
4 | $1,846 | $12,000 | |
5 | $0 (yay!) | $16,050 | |
Saving into an emergency fund, you pay off the credit card debt in about 4.5 years, and collect $16k of savings.
Scenario 2 - pay $500/month toward debt until it's gone, then build an emergency fund, no emergency happens:
Year | Credit card balance | Emergency fund balance | |
0 | $10,000 | $0 | |
1 | $5,177 | $0 | |
2 | $0 (yay!) | $420 | |
3 | $0 | $6,420 | |
4 | $0 | $12,420 | |
5 | $0 | $18,420 | |
Putting the entire $500 toward debt instead, you pay off the debt in just under two years (instead of over 4.5), and in five years you have an extra $2,370 in the bank compared to if you had paid off the debt less aggressively. This amount could be even more if you invest some of that savings instead of letting it waste away in an interest-free savings account.
"But wait!", you might say. "That's the best case scenario...what if an emergency happens?"
It turns out that you're
still better off putting your money toward the credit card debt and just putting any emergency spending on a credit card.
Scenario 3 - pay $250/month toward debt until it's gone, save the rest in emergency fund, a $2,000 emergency happens at the end of Year 1:
Year | Credit card balance | Emergency fund balance | |
0 | $10,000 | $0 | |
1 | $8,392 | $1,000 | <-- A $2,000 emergency happened. Good thing you had an emergency fund, right? |
2 | $6,526 | $4,000 | |
3 | $4,360 | $7,000 | |
4 | $1,846 | $10,000 | |
5 | $0 (yay!) | $14,050 | |
In this scenario, the debt was paid off in the exact same amount of time as in Scenario 1, and the emergency at the end of Year 1 caused your ending cash balance to be $2k lower than it would have been.
Scenario 4 - pay $500/month toward debt until it's gone, then build an emergency fund, a $2,000 emergency happens at the end of Year 1:
Year | Credit card balance | Emergency fund balance | |
0 | $10,000 | $0 | |
1 | $7,177 | $0 | <-- Oh, no! An emergency happened without any cash savings! Guess we have to charge it. |
2 | $1,901 | $0 | |
3 | $0 (yay!) | $4,040 | |
4 | $0 | $10,040 | |
5 | $0 | $16,040 | |
Even if unexpected spending rears its ugly head, paying off the credit card as fast as you can
still puts you ahead by $1,990 after five years. Not quite as good as the scenario where no emergency happens, but not bad either.
Note that this advice only applies to high-rate debt. If your credit card debt is gone and you're paying off lower-interest loans such as student loans or a mortgage, diverting some cash to an emergency fund makes a lot more sense. It's better to have some savings in that case because the last thing you want to do when you have no credit card debt is to risk getting some.