Should I Grow My Emergency Fund or Pay Down Student Loans?

Michael Lux Blog, Student Loans 4 Comments

Having an emergency fund is a great idea.  You never know when unexpected expenses are going to show up, so it is always a smart idea to have some cash stashed away.  Plus, if you end up out of a job, an emergency fund can be your lifeboat until your next paycheck.

Unfortunately, your emergency fund isn’t really earning you any money.  Even if you have a high interest savings account, odds are you getting less than 1% interest.  The interest you earn in savings will be much less than the interest on your student loan.   When this happens, you are essentially spending money each month to maintain an emergency fund.

How much should I set aside?

Not having any emergency cash is a risky proposition.  Having too much can result in unnecessary student loan interest spending.  To find your sweet spot, you first need to look at the interest rate on the loan you are considering paying down.  For this example, assume your student loan interest rate is 9%.

If you are debating between leaving $1000 in your emergency fund or paying down your student loan, your decision should factor in the interest.  Putting that $1000 towards you student loan would reduce your yearly interest by $90.  Put another way, each $1000 you leave in savings instead of paying student loans costs you $7.50 per month.

The math here is pretty simple:

Emergency Fund Balance x Student Loan Interest Rate = Yearly Cost of Emergency Fund

$1000 x .09 = $90 Per Year

Tip #1: Be Sure to use the decimal equivalent for your interest rate… so for 9%, use .09

Tip #2: To have even more accurate numbers take the student loan interest rate and subtract the interest rate on your savings account… If your savings interest rate is .35% then your effective interest rate is 9% – .35% or 8.65%

In this situation it might make sense to leave a couple thousand dollars aside as an emergency fund.  But realize you are essentially spending $15 per month to have this asset.  For many, this might be pretty close to the sweet spot.

Leaving $10,000 set aside in an emergency fund would seem too high.  That money could be saving you $75 per month in student loans!

The Bottom Line…

Saving money instead of paying down student loans has a cost each month.  You have to way your desire to have some money in case of an emergency versus your desire to pay off your student loans.  Keeping some money set aside is wise, but it comes with a cost.  To find your sweet spot, find out how much it costs to keep your emergency fund, then decide if it is worth the money.

  • The amount of savings you need is personal. Savings give you security during difficult times. How much do you need to feel secure? My true emergency fund is very small because I keep layers of resources to provide security. It also helps that our careers (RN & Teacher) are very secure and I have enough resources to handle 99.9% of what can come up.

  • I agree that this is personal, and each has a “sweet spot” where they feel comfortable.

  • JP

    I think the amount depends on the situation. If you’re a homeowner, have a car without a warranty, and a single income family, you need to consider all the scenarios where $1000 or $10000 would be crucial. I always suggest a minimum of 3 months of ones earnings for those emergencies. The last thing you need is to rack up $10k in credit card debt at 18% interest.

  • I think a $1,000 emergency fund is a bare minimum as that will cover a great deal of unexpected expenses that pop up and could cause big problems. After that, it’s up to each person or family to decide. If you can’t really decide, I advocate splitting it up: make your emergency fund bigger and pay down loans. Eventually, one might stand out as a better alternative.