emergency fund student debt

Student Loans and Your Emergency Fund

Michael Lux Blog, Strategy, Student Loans 0 Comments

Once student loan borrowers realize how much they spend on student loan interest on a daily basis, they often choose to aggressively attack their student debt.  When this aggressive repayment begins, one financial safeguard that often gets overlooked is the need for an emergency fund.  Today we will look at the need for having an emergency fund as well as how student loans factor into your emergency planning.

What is an Emergency Fund?

An emergency fund is cash that is set aside for a rainy day.  The idea behind this fund is to ensure that bills can still be paid in the event of an unexpected job loss or when unforeseen expenses arise.  Many financial professionals suggest have an emergency fund with enough money to cover at least three months worth of expenses.  Others suggest six to nine months.

Having an emergency fund can reduce your financial stress level, and help avoid unwanted borrowing when extra cash is needed.  Rather than having to pay late fees on missed bills or incurring high interest credit card debt, smart planners can dip into their emergency fund when necessary.

Many people opt for a high yield savings account so that the money is able to earn some interest, but not face any risk.

Student Loan Considerations and Emergency Funds

When calculating how much you spend each month in an emergency, including federal student loan payments probably isn’t necessary.  This is especially true for people on income-driven repayment plans.

A job loss could mean your income drops down to zero.  In this unfortunate event, federal student loan payments can be recalculated and dropped down to an appropriate level.

Many student loans come with hardship forbearances or deferments available.  These can be utilized in a financial emergency, but they should be viewed as a very short-term fix.  If you use a forbearance with no solution on the horizon, you could end up making your student loan issue worse.

Cheating the Emergency Fund Rules

Suppose you and your spouse are getting really serious about paying down your debt.  Your paycheck pays all of the monthly bills, while your spouses paycheck is used exclusively to pay down student loans.  When you have two salaries but only depend upon one of them to get by, the need for an emergency fund is reduced.  In this case the fund is still probably a good idea, but you can definitely get away with keeping it on the smaller side.

Is available credit on a credit card enough for an emergency fund?

Keeping available credit on a credit card is definitely the best financial practice, but your credit limit should not be viewed as an emergency fund.

The first problem with going this route is that the money borrowed on the credit card might not be paid back right away in an emergency.  With credit card interest rates commonly above 20%, this sort of borrowing is dangerous and expensive.

The second issue with credit cards is that they usually cannot be used to pay some of the most important bills.  Whether you pay rent or a mortgage, most people have to make these payments in the form of a check or bank account withdrawal.  The same problem exists for utilities and student loan payments.

Money Invested isn’t for Emergencies

Having money invested is another good financial practice, but it really shouldn’t be considered an emergency fund.

Many investment accounts, such as 401(k)s and IRAs impose stiff penalties for early withdrawal.  With these accounts, not only do you lose out on future investment growth, but you have to pay taxes on the money withdrawn and you have to pay at 10% early withdrawal penalty.

Even if your investments are not in a retirement account, withdrawal in an emergency can still be a big mistake.  For many people, the last financial emergency happened during the last recession.  Investment values dropped by over 50% and many lost their jobs.  People caught in this situation ended up selling their investments at rock bottom prices.  Had they had an emergency fund, they could have left their investments alone while the market recovered.

Bottom Line

Aggressively paying down student debt is a great idea.  However, it is important to set aside some money in case of a rainy day.  It can be frustrating seeing money sit in a bank account earning less than 1% while you are paying 7 or 8% interest on your student loans, but if things ever get ugly, you will be glad you had the money ready to go.