Should You Pay Back Student Loans or Build an Emergency Fund?
Student loans are more common than ever. Millions of Americans carry enough student loan debt that they may cause significant financial stress well into their 40s. With such huge balances and painful monthly payments to deal with, it’s easy to understand why people want to get rid of their student loan balances as soon as possible.
Though paying off your student loans is a good thing it’s also very important to set up an emergency fund -- one of the key tenets of smart personal finance. Given that it is difficult to pay off your loans and build an emergency fund, it can be difficult to decide which should take priority.
Compare the benefits of paying student loans and building an emergency fund. That information will help you decide which to focus on.
Student loans are an incredibly valuable tool because they help you cover tuition and living costs while you’re in school. It is likely to be the first form of debt that you've ever had. Unfortunately, it is also likely to be one of the most significant debts you'll ever have.
Student loans typically come with repayment terms of 10 to 20 years, with the goal of making monthly payments manageable. It can be tempting to pay off the balance as quickly as you can, but there are some arguments against prioritizing student loans over other things.
Different types of student loans
There are two main types of student loans: government loans and private loans.
Government student loans come with a number of benefits that private loans do not. Many government loans are subsidized. That means that interest will not accrue while you’re still in college. This is a valuable benefit given that student loan rates tend to range between 4% and 7%. Private loans often charge higher rates.
These rates are far lower than other types of loans and credit card debt, but still large enough to have a large impact on your finances.
If you have $37,000 in student loan debt and plan to pay it off over 20 years, you’ll pay $244.18 per month assuming the loan charges 5% interest. Over the course of the loan, you’ll pay over $21,600 in interest.
That can create a huge drag on your ability to save. Paying your loan faster will reduce the interest that you end up paying during the life of the student loan.
The case for keeping student loans
Despite the interest costs, there are a few advantage of student loan debt.
Government loans may provide various deferment programs that may allow you to reduce or freeze monthly payments until your income is able to manage the standard repayment amounts.
If you work for a non-profit, you might be eligible for loan forgiveness. Under a loan forgiveness plan, the remaining balance of your loan will be forgiven after a certain number of years. Getting a large balance forgiven can be huge savings.
Another benefit of student loans is that you can deduct a portion the interest on them from your income at tax-time. That reduces the effective interest rate on the loan.
Special rules in bankruptcy
The biggest downside of student loans is that it is nearly impossible to get them discharged during bankruptcy. If you declare bankruptcy, though your other debts might go away, you’ll still be responsible for your student loans.
The only way to discharge student loans in bankruptcy is to prove the following three things in court:
- That you made an honest attempt to repay your student loans
- That you would be unable to maintain a basic standard of living if you are forced to repay your loans
- That your inability to maintain a basic standard of living would last for a large percentage of your repayment period
An emergency fund is exactly what it sounds like. It is an amount of money that you set aside for use only in the event of an emergency. Whether it be a medical emergency, car breakdown, or another unexpected expense, an emergency fund can help you pay for it.
Emergency funds are very important because they let you avoid taking on expensive debt to pay for emergencies. If you don’t have any savings and your car breaks down, you’ll need to take out a loan to pay for the repair. This can turn a $500 repair into a $1,000 repair after you deal with loan fees and interest.
The ideal amount for an emergency fund
There’s a lot of advice out there regarding how much money you should keep in your emergency fund. The usual recommendation is that you keep 3-6 months of expenses in your emergency fund.
For example, let's say your monthly housing cost (rent or mortgage) is $1,000, your monthly food expense is $300, and your utilities and commute costs are another $300. Your total monthly expenses combine for $1,600 for the necessities. The size of your emergency fund should be $4,800 to $9,600.
How to set it up
You can start building an emergency fund with just a small amount. The best way to start is to open a savings account at an online bank. This will keep the money separate from your spending cash at your main bank. Online banks also offer the best interest rates so your money will be working for you while it sits in the account. Because online banks don't pay the costs of running physical branches (e.g., real estate, employee salaries, utilities, insurance, etc.), they are able to provide much higher savings rates.
Start by transferring as much money as you feel comfortable contributing. Then, decide on your target for the size of your emergency fund. You can build the fund in one of two ways.
One way is to direct all your excess cash to the account until you hit your target. This requires the discipline to actually save the money and not spend it.
Another option is to set up automatic transfers from your checking account. Cancel them when your account is fully funded.
Once you’ve built your emergency fund, you’ll have to resist the temptation to use it for non-emergencies. You should only use the money in the emergency fund for true emergencies. Having the discipline not to spend it frivolously means you’ll have a safety net for a true emergency.
Which to Focus on First?
The question remains, which should you focus on first?
You should focus on your emergency fund first... to a point.
The reason for this is that certain emergencies can put you deeper in debt if you don’t have an emergency fund. If you use a credit card to fund emergency expenses, you’ll be paying as much as 20% interest until you pay off the balance. That’s far higher than what you’ll pay on student loan debt. If you’re sending all your excess cash to your loan balance and hit an emergency, you’d have been in a better situation overall had you made smaller payments and saved some of that cash.
You should build an emergency fund first, but possibly not a full 3-6 months’ expenses. Saving that much can take a while. You can get the best of both words by saving a few thousand dollars in an emergency fund to start with. Just make minimum payments on your student debt and use the extra cash to build your savings.
Shifting your focus
Once you are comfortable with the size of your emergency fund, you can start making larger payments on your loans. At this point, you may even begin to consider a gradual entry into other investments.
Student loans have relatively low interest rates. Those rates are effectively reduced further by the student loan interest tax deduction. Because of the low cost of student loans, you might be able to come out ahead by investing your extra money.
The American stock market has returned an average 9-10% per year, though the variance in returns for an individual year is large. If you have a student loan that charges only 4-5% interest, you have a good chance of coming out ahead by investing instead of making extra payments. At the very least, you should make sure to take advantage of any 401(k) matching contributions your employer provides. By contributing funds to get a match, you can get an immediate 100% return.
As with all things in personal finance, the decision on whether to invest or make extra payments on your student loans is personal. You may feel more secure by beefing up your emergency fund first.
Building an emergency fund is one of the first things any new college graduate should do.
It’s so important to have an emergency fund that it should take priority over making extra (or larger) payments toward your loans.
Once you have a sufficient emergency fund built up, you can start to consider paying down your student loans or exploring other opportunities for your hard-earned money.