Should I pay down debt or build up my emergency fund?

magnifying glassRead these two inquiries I recently got from members of the community, then tell me if you can see how they’re really the same question:

Hi Mark,
I have been using YNAB since June after winning a version of the software in one of the online classes. I’m very pleased with the program and how it’s aided me to get back on my feet (I finished a PhD a year ago and started a “real” job).

I’m carrying about $11,500 of credit card debt at 9% interest and student loans of $70,000 at 2%. I’m fully buffered and have a bit of savings ($1500 cash and some RRSPs), with overtime payments and tax returns on the way in the next 5 months.

Should I be putting everything towards the credit card debt or keep my buffer? After my overtime pay and tax return I will be able to eliminate the credit card debt. Do you have any advice?? I’d love to get budget critiqued, but I suspect you have a lot of them in your inbox!!!

– B

Followed by a question from “H”:

My wife and I have been YNABing (yes, YNAB has become a verb in our household language) since July 2013. We’ve had a rocky start, and are just now really hunkering down on our budget. I recently received a significant pay raise and feel like I’m right on the edge of doing something awesome with my newly found income, or doing something really stupid. Do you have any advice for people who have just received additional income and want to play it smart?

– H

YNAB’s Rule One asks: “What does this money need to do before I’m paid again?”

Tweak the question slightly: “What is the highest-performing use of my available money?”

If we’re talking “highest-performing”, we’re talking “earns the highest interest rate”, right?

Right, but it gets sticky when you have to deal with B’s all-too-common question about storing money in a “buffer” or emergency fund rather than using it to pay off debt. I’ve done my own share of hemming and hawing about this question, and I may well have already given a different answer than the one I’m about to offer.

Here’s my latest take:

When deciding how to best use available cash (including “buffer” money, new income, and even current spending), look through the lens of “risk of new interest expense.”

Existing debt gives a 100% probability of interest expense, so it would be the primary focus of all available money, even at the expense of a smaller emergency fund.

Rainy Day (YNAB Rule Two) budget categories might offer some risk of new interest expense; I’ve identified my cars, my appliances, and my teeth as risky aspects of my own budget. But the interest risk in each of those categories is less than 100%, so they can’t take priority over existing debt (if I’m taking the purely mathematical approach).

So, where does that leave “B” and “H” in their quest to make the best use of available funds?

Even if the math dictates otherwise, I don’t know that I can go with no buffer/emergency fund until my debts are paid off. On the other hand, this exercise tells me my own e-fund is bigger than it needs to be (it sits at about one month of expenses).

“B” – if I were you, I’d maintain the smallest buffer required to allow me to sleep at night, then throw all other cash at that credit card debt. The overtime pay and tax refund will apparently replenish your buffer quickly, and in the meantime you’ll have saved interest expense and won a major mental victory (by prioritizing debt freedom ahead of the emotional comfort of an emergency fund).

“H” – if you have any debt, start there with your new income. If you don’t have any debt, consider the fact that you still have “interest risk” in the form of opportunity cost. In other words, every dollar you spend is “financed” at the 7% to 10% you could be earning by putting that money into the market. I don’t know your other goals/needs, but debt elimination and saving for retirement are the first-best uses of your new surplus.

I’m sure there’s some really interesting, complicated math that handles individual risk tolerance/aversion and the probabilities of financial emergencies. I am but a humble blogger, but it seems like this generalized approach will serve us well.

What do you think?