Recently a close friend and I discussed a debt she wanted to payoff. She has a car loan with a balance of about $10,000 at an interest rate just north of 5%. It’s killing her that she’s paying interest on it and wants to know if she should pay off the loan with her savings.
Mathematically, if she’s earning less on her savings account than she’s paying in interest on the car loan, it makes sense to pay it off.
However, there’s a factor that isn’t considered in that equation. It’s the liquidity of money. The money in her savings account, could be used in an emergency. Payoff the debt and she can’t go back and get the loan in an emergency.
As we discussed emergency savings, she asked about the six month rule of thumb for emergency savings. A rule of thumb is often thrown out when people ask how big should your emergency fund be?
I rephrased the question to her this way. “If you and your husband lost your job today, how much money would you want in the bank?” Her answer, was exactly what she has right now.
The interest on the car loan appears to be money she’s throwing away. However, in her case, it’s actually an insurance policy against unemployment or other emergency situations. When we looked at it that way, she was much happier!
Some of us operate strictly on mathematical formulas (I usually fall in this group), some of us operate completely on emotion. But most of us are somewhere in between. The real key is finding out where on the spectrum you fall and aligning your financial decisions to that sweet spot.
By the Numbers
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Why not get the best of both worlds. Use the saving to pay off the car loan, open a line of credit with no balance to cover emergencies for now. Use the monthly payment savings to re-establish the emergency fund.
This way you save the interest and have borrowed funds in case of emergency (exactly like it is now).
All for paying off debt and having an efund but modified question I would ask is, “If you paid off loan using efund, how long would it take to get it back to where it was?” If cutting some expenses and perhaps stopping some investment contribution (ie 401k) would help, then look into it.
I took out a line of credit for emergency spenditures, used most of my savings to pay off debt and felt secure until my line of credit was revoked when the economy went south. Luckly I have not had an emergency but now I feel as if I should have kept my savings and continued to pay the debt over time
I’m in a similar situation, but with 2.8% student debt. This is much lower, and keeping it in a saving account, I’m down just 0.79% (SmartyPig!), but I like the idea of being covered and also having the ability to continue to pay should something happen.
And of course, with a student loan, the interest is tax deductible for many people.
A loan that cheap and I think I’d keep it forever!
I’m taking a modified Dave Ramsey approach.
Build a small emergency fund ($1000 was too small for me, so I got it to an amount I would be comfortable with)
Snowball payoff the rest of the debts.
I recently discussed if I should include my student loans in my snowball or invest. I am going with the math and accelerating payments.
I get what you’re saying about the liquidity of money, but that is something I’m willing to sacrifice for a couple years while I’m in debt.
(PS: I haven’t completely stopped funding savings, just not as aggressive as debt payoff)
If her rate is 6% plus she should consider refinancing with PenFed at 3.99%. They are offering a $100 bonus to refinance. You have to become eligible to join, but I have that information on my site.
Good reminder about Penfed. I’m a huge fan of Penfed, especially since we keep our mortgage there at a fantastic 4%!
Yes you should to a point. When in debt paying off mode, always maintain a small emergency savings of about 1-2,000 dollars just to cover yourself. Once you have that saved up put all you got into getting the debt paid off. I like to use the debt snowball technique as it is the most effective way to get rid of your debt.
Should your emergency fund be equivalent to 6 months of your average monthly expenses? Or one year? Or is it more dependent on the general economic situation?