Should I Pay Down Debt or Save for an Emergency Fund? Maybe Neither.

One of the central pillars of most financial advisors recommendations is to get an emergency fund. We all know a certain well-known radio personality that makes that his first baby step. At this point in his life, I wonder if that radio personality still has a $1000 emergency fund. I’m guessing he makes tens or hundreds of thousands of dollars a week and that level of money just sits in his checking account without him even noticing. Of course, he is a high-income earner. So what should we do? Should we pay down debt or save for an emergency fund or something else?

As a high-income earner, what does an emergency fund look like?

Some people would define an emergency fund as the amount of money you would otherwise have to borrow to cover an unexpected cost. For higher earners, that is probably a lot more than $1000. Hopefully, you are putting 30% of your paycheck away and if an emergency came up, you just defer those savings until the unexpected expense is paid off.

If you are using your credit wisely, like I recommend in Baby Steps for High-Income Parents, then you should have at least a month’s leeway to pay a fairly high expense before you need to cover that emergency.

I think you will see that this is a very individualistic decision. Depending on risk tolerance, priorities, job stability and the interest rate on debt, you and your family might make a different decision about whether to pay off debt, max out your emergency fund or do something else.

What if the charge is more than I can pay in a month?

Again you should have options and these will change as time goes on and you continue saving.


Let’s look at three stages of different high wage earners.

  1. There is the just starting out, paying off student loans, car loans, credit cards and contributing to retirement accounts with a company match phase.
  2. There is the paid off all debt, trying to maximize investments but not financially independent and also might want to save for kids college phase.
  3. Third, there is the financially independent, retired or only working because you love it, and kids set for college expenses phase.

In the first scenario, you have debt. Avoiding more debt should be one of your primary goals. A lot of people would argue taking advantage of any retirement accounts like a 401K with a company match should be your second. Some people also say you should maximize your Roth contributions earlier, rather than later. If you don’t, you lose the time advantage of compounding tax-free interest.

In the second scenario, you don’t have to worry about debt so you can either increase your cash/savings account emergency fund or max out a debt-tackling taxable investment account.

With the third scenario, you are set as far as retirement accounts. Depending on your risk tolerance, you can have a cash emergency fund but in reality, all your retirement funds are one gigantic emergency fund. How you allocate it is up to you and your ability to take a risk.


What does it mean to tackle debt?

How does an emergency fund fit in when you need to tackle debt?


If you pay off the debt, that is a guaranteed rate of return. What matters is the debt interest rate. If it’s a mortgage at 4% that is totally different than credit cards at 20%.

My rule of thumb is if the debt interest rate is over 7% I would pay that first. Others may be more conservative or aggressive. After that, I would create a “debt-tackling” fund in a taxable account and invest in low expense index funds. There will come a time where the debt-tackling fund is the same as the debt and you can decide to pay it off in one fell swoop or just keep making minimum payments and building up the “debt-tackling” fund.


Hopefully, this canyon doesn’t remind you of your debt. 


This isn’t without risk. If you decide to take this route and lose your job right when the market tanks, you could be in a tough spot. You might be underwater on investments and under water on the debt. You also have to remember that you are going to have to pay 15-23.8% on the gains in that account when you sell, depending on income. Factor that in when you are debating on paying debt versus investing.

Let’s look at some different scenarios.

Let’s say your salary is $200,000 a year. Your take home is about $135,000.  You have $10,000 in credit card debt at 19.9%, $80,000 in student loan debt at 6% and a $300,000 mortgage at 4%. Living expenses are $8000 a month making minimum payments on your debt. That leaves you about $3250 for either debt payoff, building your emergency fund and/or investing. You have decisions:

  1. Save six months expenses ($48,000). It will take 15 months to accumulate that if you take the extra $3250 a month and put it in a savings account earning 1%. Then you can start throwing that $3250 at credit card and student loan debt.
  2. Save six months expenses ($48,000). It will take 15 months to accumulate that if you take the extra $3250 a month and put it in a savings account earning 1%. Then you can start throwing that $3250 at the (debt-tackling) taxable account.
  3. Just pay off the credit card and student loan debt as quickly as possible. Put the rest in a (debt-tackling) taxable account. No emergency fund.
  4. Put all the money in a taxable account. Invest in a total market index ETF until you feel like paying off the debt. No emergency fund.
  5. Pay off the credit card debt. Put the extra money every month in a taxable account. No emergency fund. It will take you about 3 months to pay off the credit cards.

Let’s say you started this process in January of 2004. and then look at where you would be right after the financial crisis and start of the recovery at the end of 2009. Look at the chart below to see how all your accounts would end up.

Pay down debt or Save for an Emergency Fund


This is what the different scenarios would look like after going through those six years. Of course, if you lose your job then things could change. The most likely time you would loose your job is during the crash. Even though the “Debt Tackling” account value went down in 2008, it wasn’t so low that you couldn’t sell some investments and live off of the proceeds if you lost your job at that time.

One variable is whether or not you can trust yourself to continually contribute to the account. Would you take a vacation or buy a fancy car instead if you had money in the taxable account? If you paid off the debt instead, you wouldn’t be able to spend the money on non-essential things.

I know there are so many other variables to factor in, it is impossible to predict every scenario. Only you can answer all the questions on this topic, but I think going through the exercise is important before you make a final decision on where you will put your money.


Don’t forget about opportunity cost?

Opportunity cost is the benefit that is lost when one decision is made over another. It should be something that you think about every time you make a money related decision.

When you are thinking about the safety of an emergency fund, remember the potential investment income. You are forgoing this income when you keep the money in a safe place like a savings account.


So what do I do for an emergency fund?

When I started making a decent salary years ago, I needed to save to pay off a car loan and my student loans. I just went by the conventional wisdom at the time and put the money away in a savings account. I believe I was getting around 3% then. Thankfully it only took about 18 months for us to pay those debts off and then I started investing in a taxable account.

After paying off my loans, we bought our “dream” house and that added more monthly expenses so I wasn’t able to invest as much as I would like. Since then I’ve made partner and my salary increased so we are on track to save much more since those first few years.


What is the best decision?

If I had to do it over again, I would have adopted the strategy in scenario five. We didn’t have any high-interest credit card debt, but we had the car loan and student loans. The car loan was around 4% and the student loans were at 3.25%. (I was lucky, back then you could really get the rates down right when I graduated if you consolidated.)

I would have put the money away in a taxable account. If I had any high-interest debt, I would have tackled that first and then built up a taxable account until I could pay everything off in one fell swoop.

To me, the advantage of having liquid assets is more important than paying off low-interest debt quickly.

I can’t fault anyone for wanting to pay off student loans ASAP, especially if the interest rate is higher and the fact that they don’t go away with bankruptcy.

Like I’ve said before, this is a personal decision. If “debt” is a four-letter word to you, then pay it off.  Being able to sleep at night is more important than maximizing every last potential dollar. There are a lot worse things you could do with your money than pay off debt. Just look at the opportunity cost, the returns and examine yourself and motives before making your decision.


So what do you think? What scenario would you pick? Would it be none of the above? Let me know your debt pay off and emergency fund strategies. 


Tom is a doctor, husband and father of five with a passion for parenting and finance. When he isn't skateboarding, riding BMX, or jumping on the trampoline with his kids, he is reading and writing about personal finance. He helps high income parents educate and mentor their kids to become financially, emotionally, and intellectually self sufficient.

26 Responses to “Should I Pay Down Debt or Save for an Emergency Fund? Maybe Neither.

  • Interesting perspective on paying off debt and saving! It makes sense mathematically to take advantage of high interest rate investment. However, Mr. FAF and I hate debt, so we just try to it off as fast as we can. We currently have no consumer debt and are aggressively trying to pay off our mortgage.

    • Like I said at the end, you have to be able to sleep well at night with your decisions.
      If debt eats away at you, get rid of it. You’re in a much better financial situation than most folks.

      Tom @ HIP

  • I love the way you broke it down in that chart and I have to say I am shocked at the differences between them in just that 5 year time span! I’m not completely anti-debt, although the only debt I have is my mortgage. We have enough equity in our home that I have no reason to be concerned about selling it, even if the housing market takes a turn for the worst. I’ll be investing instead to (hopefully) earn a significantly higher rate of return on my money.

    • I’m glad you liked the chart. It really helped me see how different strategies can play out but ultimately we all have to do what we are comfortable with.

      Tom @ HIP

  • Nice table! I am for maximizing 401K’s and other tax advantaged accounts first (get that match). Then paying off consumer debt >4% (credit cards, other loans). Then saving in your IRA and the rest of your 401k. After all of that you can decide what is more important to you- being debt free (school loans and mortgage) or starting a taxable account for investments.

    As for your thoughts of putting money in a taxable account before paying off loans, it makes math sense. Plus, if I die, my $170K of student loans disappears. Less debt my wife has to deal with. I do wonder how taxes on the capital gains would affect the total returns on that taxable account when withdrawn to pay off student loans?

    • Thanks EJ. Good point about the student loans disappearing. I didn’t think to include that.
      With our incomes we are going to take a decent hit on the investment income when selling the long term capital gains.
      In my example I thing the average yearly gain on the taxable account was 3.5% so knock off 15-23.8% of that. The taxable account would still outperform the emergency fund though.

      Tom @ HIP

  • steveark
    8 months ago

    You really did a heroic job tabulating all of that data! As an engineer I love it when experts support their opinions with the numbers. While you do differ from the Radio Guy I think you are in the minority of people who have enough self awareness and self control to pick math over emotions. I do agree with the RG that many people, maybe most, aren’t safe when they do that but unlike him, I know many are totally safe managing some risk in order to maximize the return. In my case I’m early retired and my emergency fund is at almost five years of expenses so that I never have to face a bad sequence of returns. But five years of expenses is only a small part of my nest egg so it doesn’t cost me much to keep that liquid. One thing I’ve noticed from being on the other side of the FIRE goal, all the hard decisions are on the front side. Life is pretty easy and straightforward once you get here.

    • That is good to hear that things get easier. I’m looking forward to it someday.
      Once you’ve won the game so to speak conservative financial management is probably going to work out just fine.
      I’m hoping to bring FI a little sooner by playing the percentages. I also have a more stable job that a lot of people, so that is something I consider when making my decisions. Thanks for reading.

      Tom @ HIP

  • Great analysis, Tom. As a high income earner, I maxed out my 401(k) and paid off debt aggressively in parallel. During this time, we had a size able emergency fund – around 6 months of expenses.

    Eventually, we tapped into our emergency fund to fully pay off our debt ($97k of student and car loans.)

    Now that we are left with only our mortgage, I am trying to figure out what makes the most sense. And yes, I agree with most people that you can get a better return investing in the market. Our emergency fund provides a nice sense of comfort – as much as I’d like to invest the money we will keep it in a savings account.

    • Thanks for reading and commenting Taylor. Congrats on tackling that debt.
      I’m definitely not saying that emergency funds are bad or wrong.
      The main point I wanted to make was if you look at the scenarios above, the difference between 1 and 5 was $75,000 over a six-year period in net worth. As long as you can say if things worked out the peace of mind of an emergency fund is worth $75K then you made the right decision.
      Of course, if you lost your job or had a medical illness then things could work out a lot different. It’s all an educated guess but the more educated we are the better we can guess. 🙂

      Tom @ HIP

  • Ronda
    8 months ago

    I found your blog this month and have to say that I have found so much value out of every article you have written. Previously, I had read blogs that always seemed to focus on paying off debt rather than saving. I really like the comparison you have on this article and feel like it really put into perspective that it isn’t best for net worth to just focus on paying down debt and like the concept of debt-tackling taxable accounts. Radio guy would tell me to sell my assets to pay off my debt, however, at only 3% interest it never made sense to me to do that and lose that liquidity.

    My question to you on this article is your $200k family with a net income of $135k isn’t putting anything towards their 401k available. Also, in previous articles, you mention at least a 30% savings rate. How do you recommend that 30% is spread out? On your baby step article, you allocate the max to 401ks however, only leave 3% to go to the taxable account. If a person opened up a Solo 401k would you recommend the max of $53k if available? I like the liquidity of the taxable account, however also want to maximize tax-deferred savings. What do you find to be the best balance between tax-deferred and taxable income? Does your opinion change if you have debt, however, all of it is less than 4%?

    I look forward to your reply and your future articles. Keep up the great work!

    • Hey Ronda. Thank you for reading and the kind words. I will try to keep the helpful articles coming!
      Let me try to answer all the questions as best I can. If you operated as a sole proprietor and make $200k a year, you should be able to contribute the full $54K or very close to it in a solo 401k.
      This is kinda sticky situation because I think your projected retirement tax bracket should factor into your decision to contribute fully to a 401k or not. If you are planning on being in the 15% bracket or less in retirement, then it might make more sense to contribute a greater amount to a 401k than if you were planning on being in the 25% or 28% bracket.
      The problem with fully funding the 401k is you lose a lot of liquidity.
      If I were in a company situation where I received a match for my 401k contribution, I would at least contribute enough to receive the match from the start. That would probably only be a few thousand dollars though in most situations.
      As for the rest, I would divide the 30% in this order.

      1. Pay debt above 6% as fast as I can.
      2. Fund taxable account until it matches remaining debt.
      3. Max out tax deferred options after that.

      If all the debt is less than 4% I would just make minimum monthly payments and build up a taxable account.

      As an aside, I just plugged in the scenario of a married couple, 2 kids, full contribution to a solo 401K ($54K) with starting income $200K. Because of the solo 401k, taxable income was $146K. The mortgage interest deduction $9000, property tax $5000, fully fund his and her IRA’s. Taxes calculated to $19K federal. I didn’t include state taxes (say the couple lived in Florida). The take home income was $127K. If monthly expenses were $8K, that still leave $2500 to put towards debt or a taxable account. (I included the $1000 a month or so it would take to fully fund IRAs in the expenses, if you say that is on top of the $8K expenses, then that only leaves $1500 a month for debt/taxable account).

      As you can see there are a ton of variables we can play with. I’m sorry if that was hard to follow.
      If you have the time, calculate it out fully funding a solo401k versus funding a taxable account and see the difference. Then if the peace of mind of higher liquidity is worth the difference, choose that.
      I hope this helps and if you want to go over specifics feel free to email me. I will try to help as best I can.

      Tom @ HIP

      • Ronda
        8 months ago

        I have thought about your reply most of yesterday and even tried to come up with my own calculator to calculate my own personal different scenarios. During this, I realized that I almost already have my debt-tackling account funded to pay off auto loans (3%) and student debt (1.6%). So my question in my mind is to use that money to pay off the debt now or continue to build the debt-tackling account. If the market drops I see your point made earlier that if you lost your job in a down market it would not be a good position. I also noticed that when I want to plan to put 30% away into savings that my auto loans and student loans are taking 10% of my income and makes it difficult to save the 30%. Is the debt payments part of the savings rate if a person choices not to use their debt-tackling account to pay off the debt? Also, I wonder in your quick fire simplicity article you state not to get an auto loan, why when the interest is so low? Would you be willing to share your above spreadsheet for others to use to input their own scenarios to see the different net worth values? What calculators do you use to determine these figures, Excel or another website? Thanks!

        • Hey Ronda,
          As a general rule, I don’t like to use debt to buy a depreciating asset like a car. If you have the cash to invest instead of buying a car, I understand you could make more.
          If you think about a car as a continual necessity, the first time you buy a car with cash, you then start saving for the next one in a taxable account. Then you are basically investing your money instead of borrowing car loan money to invest. Maybe you would make a little more if you started the process with a loan, but over a lifetime it will be negligible if you just pay cash for your first car and then pay cash with savings from then on. You could definitely invest the savings along the way.
          I don’t have a all encompassing spread sheet where we can just plug in numbers because the sequence of payment of loans and investing factors into the number that are produced. Depending on the order you choose, the outcomes differ.
          Some calculators that I use are a simple compound interest calculator. You can find those lots of places.
          I use a mortgage payment calculator with amortization.I use the tax-caster from turbo tax. to estimate taxes.
          I used the boglehead wiki for annual total stock market returns to estimate previous returns. There is an awesome app for iOS called “EZ Calculators” that has a ton of amazing calculators I use. Its free!
          I want to write a blog post going through all the calculations and the calculators soon so that everyone could go through the process.
          Thanks for all the awesome questions. I’ll try to get the post out in the near future so that others can see the process of breaking down the calculations.

          Tom @ HIP

  • Dood, el Farbe
    8 months ago

    Huh. I’ve always been in the “pay down the most pernicious debt, first; then the next most pernicious, etc.” camp. Not because I ever even bothered to stop and think about it – just because that’s what I had always heard from the gurus.

    Many thanks for the eye-opening here. We don’t really have any debt other than a mortgage with I think 9-10 months left on the standard 15 years (we’ve been talking about just closing it out but… inertia).

    But this will definitely be in discussions with the kids as an option once they hit the work world and start taking on (hopefully small) amounts of debt.

    • I’m glad the article could inspire some talk with your kids and possibly give them a better financial future. Thanks for reading.

      Tom @ HIP

  • I think I’m trying to go from step 1 of your three stages of different high wage earners, directly to step 3. I’m definitely not one to shy away from what I consider “good” debt – used to increase your returns. So I may not be debt free for a while but still FI in the sense that my passive income far exceeds my debt & expenses. Thanks for breaking it all down.

    • That would be another interesting option on the scenario breakdown table. Do I buy a rental property or pay off student loans? The passive income would also be another reason not to have an emergency fund or as large a fund if you lost your primary job and still had passive income streams coming in.

      Tom @ HIP

      • So are you going to write that post or should I? hahah… I’m not sure how it works for you, but I get paid on what I billed two months ago. So the nice thing is that at this point, even if I stopped working, I would get paid for 2 months. I feel that minimizes the need for such a large emergency fund. Hate holding cash…

        • We pay ourselves on a four month rolling average to smooth out paychecks. It took my about six months to ramp up to full capacity with the two month lag on getting paid at all. So yeah, I kinda have an emergency fund built in as well.

  • Really like the info, great post. I have to agree with scenario in number 5. Pay off all high interest consumer debt, invest, and tackle lower interest debt much slower. My rule of thumb has been pay minimums on things with low interest, say 4% or less. The money is much more accessible in case of emergencies.

    • Thanks Larry,

      Scenario 5 definitely makes the most mathematical sense, but everyone needs to decide the worth of their own peace of mind. Thanks for reading.

      Tom @ HIP

  • Chris
    8 months ago

    Having an emergency fund is #1 for me.

    Your financial analysis ignores the psychological aspect of having cash on hand for true emergency expenses. Far too many people borrow for “emergencies” by pulling out a credit card. Since you’re not limited by available cash, “emergencies” have a tendency to start coming more frequently and piling up credit card debt. It’s interesting how often an emergency expense can instantly becomes a non-emergency when there simply isn’t any cash to pay for it.

    Anyone who qualifies as “high earner” should have no problems putting aside $1,000 (or whatever amount is suitable). One pay check should mean the emergency fund is fully funded.

    I also don’t think that high earners really need much more in emergency funds since emergencies are typically health problems or repair related. Anything of significant value should already be covered by insurance and ongoing maintenance precisely to avoid the hassle and expense of dealing with an emergency. That leaky hot water heater can be replaced when it’s convenient (and possibly on sale), not when it suddenly fills the basement with water and cost 10x to cleanup and repair.

    There haven’t been any “emergencies” in our family over the past 10-15 years that have exceeded $1,000. Aside from one trip to the emergency room (covered by health insurance), the only other thing I’d consider an emergency is car repairs. With two working vehicles in our family, that barely qualifies as an emergency in the first place. An emergency fund has far more value for people who can’t pay for almost any real emergency with their next paycheck.

    • I guess we have two different definitions of an emergency fund. I consider an emergency fund an amount of money that you wouldn’t be able to pay from a single paycheck and you need to save for it.
      If you are bringing in $10K plus a month and saving 10,20,30% of it, $1,000 is nothing.
      I know there are plenty of people that $1,000 is a significant portion of their monthly income and to them, I applaud them for having that amount saved.
      I see your point about someone using a credit card to fund an “emergency” when it could have been delayed. If your the type of person that can’t control spending with a credit card, doesn’t budget consistently and it takes having cash on hand to warrant spending, then I can see the benefit of a cash emergency fund.
      The point I was trying to make, is putting a huge sum of money in cash just in case you lose your job or have some other catastrophe will create opportunity cost as shown by the chart. If you are willing to pay that opportunity cost, then go for the cash emergency fund and sleep well at night. It’s certainly better than wasting the savings on something.
      I hope I’m conveying my thoughts well. If you have any other questions, don’t hesitate to ask. Have a great weekend.

      Tom @ HIP

  • Really interesting chart, Tom, what an incredible difference in the scenarios. We only have mortgage debt at this point, and with what I think is an adequate emergency fund at this time we are investing. I will send this to some whom I think it will help to make decisions on their debt. Thanks for sharing.

    • Thank you Amy. Figuring out those numbers were surprising to me too. Especially over a bear market. I hope it helps.

      Tom @ HIP

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