Should we use emergency funds to pay off debt?

The answer isn't purely about financial considerations. It's a matter of judgment, too. Our expert weighs in.

By Walter Updegrave, Money Magazine senior editor

NEW YORK (Money) -- Question: My wife and I have saved an emergency fund of $30,000, or about six months' worth of living expenses. We also have about $150,000 in student loans from law school, $50,000 of which are private loans with a 7.87% interest rate.

We already make extra monthly payments on this loan, but we're wondering whether it makes sense to use some or all of our emergency cushion (which is earning only 5.05% in an online savings account) to pay down the private student loan. What do you think? - Jim, Boston, Mass.

In a purely financial sense, you're right to question the wisdom of keeping $30,000 in an account that's paying just over 5% in interest this year, when you could use that money to pay off a loan that's racking up interest charges to the tune of 7.87% a year.

If you're in the 25% tax bracket, it's costing you about $635 after taxes this year to have that money sitting in your online savings account rather than applying it toward the loan balance.

(I'm assuming that the interest on your online savings account is taxable and that your school loan interest is tax deductible, which you can check by going to IRS Publication 970: Tax Benefits for Education. If the loan's interest isn't deductible, then the cost of keeping your money in the online account is even higher, although either way the cost goes down each year as you pay off the loan.)

But there's more to this decision than just comparing the rate on the loan with the rate on your savings account. There's also a judgment issue here.

The point of keeping the money in the savings account isn't just to maximize your return. If that were your only goal, you probably wouldn't invest in that type of account at all. You'd put your thirty grand in a combination of stock and bond mutual funds, which are likely to pay a much higher return over the long term.

The real reason you've got your $30,000 sitting in a savings account, though, is for security. You want to be sure that, in the event you're laid off or you face some unexpected large expenses, you have a reserve you can count on, regardless of whether the market is up or down.

Your savings cushion also gives you an extra measure of flexibility. You've got some financial breathing room should you decide to change careers or start a business or just take some time off.

So the question is, how much is this security and flexibility worth to you? Is it worth $600 bucks a year? Half that? Twice that?

The answer depends, in part, on how close you like playing it financially. If you're the type of person who starts chugging Maalox at the mere thought of being unemployed and seeing bills pile up, then I'd think $600 or even twice that might be a reasonable price to pay for security.

If, on the other hand, you don't mind living on the edge and doing a bit of financial scrambling now and then, well, it might not bother you to have a much smaller reserve cushion.

Your attitude about debt is also a consideration. Some people just hate the idea of having loans hanging over their heads and consider paying them off a top financial priority. If you're in this group, you might feel more comfortable paring this obligation down any way you can.

But if owing money is no biggie - assuming it's a level of debt you can easily handle - then there's not much of an upside in wiping out your cushion to pay off a loan, especially one you're already making extra payments on.

Clearly, these are issues you and your wife will have to sort out on your own. But my take on your situation is that it wouldn't make sense to cash out the savings account and put the thirty grand toward the loan. What if you lost your job and needed ready cash to pay your bills? It's not as if you can get back the extra money you paid on the student loan.

In my opinion, going without an emergency cushion is dangerous, kind of like working the high wire without a safety net. Maybe it's okay for a few hardy souls, but it's unduly risky for most of us. I could see, though, making a decision to get by with a smaller emergency reserve - say, three months' worth of expenses rather than six - if you think that would give you sufficient wiggle room during a setback.

If you go to a three-month reserve, you should also take out a home equity line of credit or, if you don't own a home, a line of credit attached to your checking account, so you have another resource to tap should you come close to running through your savings account. (You can check with banks in your area about personal lines of credit. For the best rates on home equity lines, check out our Loan Center.)

So I suggest you and your wife have a little talk about what premium you place on financial security, how quickly you think you could bounce back from a financial setback like losing your job and how big a priority it is for you to get out of debt as quickly as possible.

The fact that you've gone to the trouble to build a six-month cash reserve already tells me that you must be pretty responsible people who take their finances seriously. So I'm sure you'll come to a decision that's right for you.

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