Should I Build an Emergency Fund or Pay my Students Loans off first?

Should I Build an Emergency Fund or Pay my Students Loans off first?

Paying off your student loans and building an emergency fund are both important goals to attain financial independence. These are also essential steps you need to take to reach your goals of living comfortably during retirement. Naturally, you want to experience a debt-free life, yet focusing on repaying your debts now could mean sacrificing your retirement funds. So, how do you choose the right place to allot your extra money?

Should You Pay Off Your Student Loans Now?

If you decide to pay off your debts first without putting money on your savings, then you will only have your credit cards to fall back on in times of a financial emergency. By using your credit cards in funding your expenses, you may incur even more debts. In addition, postponing your life savings will take you farther to your retirement goals. On the other hand, if you save earlier, you will obtain the benefit of several years of compound interests on your investment.

What Happens if You Save First?

When you choose to save now instead of paying down your debts, you are likely to waste your resources on credit card interests. Unfortunately, interest rates on your credit cards are much higher than savings interests, so you will end up spending more on debt interest that earning on your investment.

Another downside of building your emergency funds first is the risk of reaching retirement age with massive debts. You will not be able to live comfortably with meager retirement savings while paying your loans. So, you may have to work harder for longer years until you are able to pay off your debts – even if this means living an uncomfortable life.

Should I Build an Emergency Fund or Pay my Students Loans off first?

When Is Saving More Important?

If you barely have any funds or liquid savings that you can use during an emergency, then you should allot at least five months or so to build one. A practical emergency fund is six months to a year of living expenses, but it may take a number of years to build this type of savings. So, you should focus instead on putting at least $1,000 in your savings account, which should be enough to cover minor expenses such as car repairs or home renovations. When you have built your emergency fund, you can start focusing on paying down your debts.

Additionally, you should take advantage of any offers that will match contributions to your existing 401 (k) plan. What’s more, there are tax benefits to your retirement savings, and the money you allot to your 401 (k) can be excluded from your disposable income, thus leading to lighter tax problems.

From a financial viewpoint, if the interest on your student loan is lower than your savings interest rate, then you can expect higher returns by saving than paying off your debts. This is the typical case with student loans that have low interest rates. However, even debts with low interests reduces your net worth and causes you to feel burdened.

Bottom Line

The best thing to do is to find a balance between the money you spend on your debts and emergency savings. For instance, if you have an extra $1,400 monthly, you may use $700 for your debts and $700 for your savings. This way, you can reduce your loan debts without sacrificing your emergency funds.

What do you think? Should you build an emergency fund first or pay off your Student Loans?

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  1. We don’t have student loan debt but we do have some credit card debt to still pay off. But I was getting nervous that we had burned through our savings over the past few years so we have been working on building that up in case of emergency, as you mentioned. I would love to be able to do both, pay off all debt and buildup our savings, but it takes time.

  2. Kevin, good post those are great points. I am in favor of paying off all debt before you save for the emergency fund. Amortize the debt on the student loan, figure out how much you would be paying in interest over the life of the loan. Then add another $100 or more per month and see how much less you would pay and how much quicker you pay it off. It will be eye opening and I think that will give you your answer, pay the debt first.

  3. Agreed – splitting your payments is the wise path to follow. No one wants to get stuck in a situation with no emergency reserves to fall back on.

    When I was digging out of my personal debt hole way back when, I would pay a little to each debt, but included myself on the list. So even if it’s just $5 going towards each debt, every month I was that much closer to being debt free and having a cash cushion.

    Specific to student loans, the interest rate is a key concern. My existing loans are under 3% APR due to the luck of when I consolidated them. So if you have a create rate, lower than anything else you could get, sometimes it’s better to pay them off slowly and use the cash elsewhere.

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