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Emergency Funds: Should You Use Yours to Pay Down Debt?

Financial advisors often recommend clients buildan emergency fund and use it only intrue emergencies. But what about when you spend hundreds of dollars each month to pay down high-interest debt — is that an emergency? And should you dip into that fund in order to decrease your debt burden?

We asked financial advisor Adam Harding for some best practices aboutusing — and not using — your emergency fund.

Which should consumers prioritize: paying down debt or building anemergency fund?

The consumer should build an emergency fund before paying down debt. There are some important factors to consider whenimplementing that plan, however.

Consumers first need to define an emergency for their individual or family circumstances. Simply put, the scope of feasible emergencies may differ if children or pets are in the picture, for those who are business owners, and depending on whether consumersrent or own property, as well as the elasticity of demand for their employment — that is, their job security — among other factors. Then they need to do their best to quantify these risks and come up with a plan to build the necessary reserve.

They alsoneed to identify why they hold high interest debt in the first place: Was it an unavoidable expense they had to put on a credit card? Was it spendthrift tendencies? If avoidable behavior is the reason for the debt, they need to correct it, or the debt could continue to balloon.

After understanding the cause of the debt and determining the requirement for an emergency reserve, consumersshould aggressively pursue buildingthe reserve before making debt payments over the minimum.

»MORE: Find the best high-yield savings account for you

Should people tap their existing emergency funds to pay down high-interest debt?

In short, no. The fund needs to remain intact in case ofan emergency. However, if the financial estimate of what constitutes an “emergency” has decreased, then perhaps a consumer could justifydepletingthe reserve by a small amount.

But instead of using an emergency fund, I’d recommend debt-swapping to pay off the debt. As an example, most high-interest debt isn’t deductible, butmortgage orhome equity line of creditdebt typically is, and has alower interest rate. Thus, if an individual has an equity position in their home and is eligible for aHELOC, he or shemight be able to swap debts.

In general, anytime the individual can substitute debt for another with a lower interest rate without incurring additional fees or an increase in principal balance, they should consider doing it.

In what other cases, if any, mightemergency funds be used for nonemergencies?

Emergency means emergency. Individuals need to be honest with themselves about what an emergency really is. Rationalization of nonemergency expenses is the road to financial destruction.

Adam Harding is founder and lead advisor at Adam C. Harding CFP in Scottsdale, Arizona.

The article Emergency Funds: Should You Use Yours to Pay Down Debt? originally appeared on NerdWallet.

 

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