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. Student loan borrowers with no income can get $0 monthly payments for the duration of their time unemployed.
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. Borrowers should plan on their private student loan payments staying the same when planning the size of their emergency fund.
Other Emergency Fund Factors
The problem with “rules of thumb” for an emergency is that every person’s individual situation is different. Some people can comfortably get away with very small emergency funds while others will want to have much larger funds.
Some items to consider:
- Job security – If your company is struggling and it looks like layoffs could be coming, it is a good idea to build up the emergency fund.
- Ability to find new work – If you have a stellar résumé in an in-demand field, a long period of unemployment is less likely. People in this situation can probably get away with smaller emergency funds.
- Ability to cut costs – If a large portion of your monthly budget can easily be reduced, it means you could probably stretch an emergency fund longer. If your budget is comprised mostly of things like a mortgage payment, utilities and food, it will be harder to cut costs in tough times.
- Other resources – Do you have an open invitation for alternate employment? Would it be feasible to move in with parents if things get ugly? Having solid backup plans in place can allow for a smaller emergency fund budget.
- Risk of large expenses – Homeowners need to keep a larger emergency fund than renters because they may have to make expensive home repairs. Those with a high deductible on their health insurance will want to make sure they can meet their out of pocket maximums.
- Children – Having kids means more people counting on you to be able to weather financial hardships. Parents will want the security and peace of mind that comes with a larger emergency fund.
- Risk Tolerance – Some people thrive under pressure while others hate the pressure. If financial stress is a threat to your mental and physical health, it is important to have an emergency fund large enough to be comfortable.
Cheating the Emergency Fund Rules for Couples
Suppose you and your spouse are getting really serious about paying down your debt. Your paycheck pays all of the monthly bills, while your spouse’s 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.
Having two incomes that can each independently pay all of the bills is the ideal scenario. In that case the only reason to tap into the emergency fund would be for a very large unexpected expense or when two jobs are lost.
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.
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.