Pay Off Student Loan, or Fund Emergency Account?

Dear Debt Adviser,

I graduated college two years ago. I have one college loan left. It was originally around $6,000. It is now down to about $3,500. I have been using all my extra income to pay off the balance as soon as possible. I'm also saving an extra $800 a month in an emergency fund. I will have $10,000 in that savings account by the end of December 2012. Should I continue using all of my extra income to pay off the college loan? It has a low interest rate of approximately 6.8 percent. The minimum monthly payment is $62. Would it be better to just pay the minimum monthly payment and put more in savings? Or should I continue putting all dollars (outside of the $800 that goes to savings and my other money for rent, food, etc.) toward the loan balance? I don't have a lot of obligations and am firmly employed.

- Brandy

Dear Brandy,

Congratulations. It sounds like you are making great financial decisions. Putting aside money in an emergency savings account is the only way to avoid unwanted and often troublesome debt in the future. To assure you have the needed funds to carry you through most financial emergencies, I recommend at least six months' and as much as 12 months' worth of living expenses in your emergency fund.

Because you have a decent interest rate and a fairly low balance on your student loan, I would suggest you make only the minimum payment due on the loan but only for a short time. Just as you have been aggressively paying off your loan, I suggest you aggressively save until your emergency savings account contains six months' worth of your current living expenses. Even though you state that your employment is secure, an interruption to your income due to an illness or accident could cause problems without adequate savings. Once you have saved six months of expenses in your emergency savings account, go back to paying off the student loan with your discretionary income.

Why? Because of risk. The risk of not paying off your student loan early is fixed by your low interest rate. Paying it off now or later won't make much of a difference. The risk of handling a financial emergency, unemployment, illness or a combination of those is open-ended and much greater. So trade the big risk for a smaller one!

When you have completed paying off your student loan and fully funding the remainder of your emergency savings account, you can move on to saving for retirement. Any money you save for retirement when you are in your 20s will put you miles ahead of many of your peers. The more you save now, the less you will need to save later. Plus, you should be able to retire at an earlier age if you make saving for retirement a priority. As an example, $6,000 ($500 per month) invested each year beginning at age 25 earning 6 percent will grow to $1,000,000 by age 65. If you wait until age 45, your annual investment would need to be $26,400 ($2,200 per month) to reach the same $1,000,000 goal.

One last piece of advice -- you seem to be quite serious about managing your money successfully, and that is important. But don't forget to enjoy your money as well. While you are saving for retirement, put money aside for vacations or whatever you enjoy. I like to suggest that people put aside money they don't have yet. Take half of future pay raises, promotional increases and unexpected income and save it while spending the other half. You deserve to enjoy the fruits of your labor now as well as in the future. And you can have both!

Good luck!

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