Should I sacrifice my emergency savings to pay off a loan?

On the Money is a monthly advice column. If you want advice on spending, saving, or investing — or any of the complicated emotions that may come up as you prepare to make big financial decisions — you can submit your question on this form. Here, we answer two questions asked by Vox readers, which have been edited and condensed.

I’m debating whether to pay off a personal loan with a savings account or keep the savings and keep paying the loan. I have no other debts but that personal loan of $25K. I’m 42 years old with two jobs in Hawai’i, and it’s been frustrating. My thought is to pay it off and start all over with no savings. Please help.

Dear Personal Loan,

I followed up with you to get some more information about your finances, including the interest rate on your loan, and here are the numbers worth considering:

• Personal loan interest: 5.75%
• Monthly minimum payment: $738
• Monthly income from both jobs: $1,500
• Monthly discretionary income: $200

The original balance on your 60-month loan was $35,000 when you took it out in August 2023. In a year, you’ve taken the balance down to $24,800, which you accomplished by pulling back on discretionary purchases and putting more money toward your loan. Well done, especially on a budget as tight as yours.

I also learned that your savings account has $5,000 in it and that you’re considering pulling $20,000 out of your life insurance mutual fund. This would leave you with no money in your savings account and no money in your life insurance account — but you’d have no debt.

Is the trade worth it? 

From my perspective, you’ve successfully paid off 30 percent of your personal loan in a single year. If you stick it out for the next two or three years, you could get the personal loan paid off entirely. Yes, that means a few more years of careful budgeting and limited discretionary purchases. It also means putting more than half of your monthly income toward your debt.

If you took the other option — paying off the loan with savings and life insurance — your first priority after paying off your personal loan would be to replenish your savings account. If you save every penny that would have gone toward personal loan payments, you should have the $5,000 taken care of in about six months. 

The trouble is that you won’t have much of an emergency fund if something should happen to you in those six months. Your budget doesn’t give you much extra cash at the end of the month, and the last thing you want to do is turn an unexpected expense into unexpected debt.

Yes, there are scenarios in which a family member could help out, or you could get a 0 percent APR credit card to cover the cost and pay it off before the regular interest rate kicks in. That said, I’d avoid dipping into your savings to pay your loan if at all possible.

The life insurance, on the other hand, has possibilities. If you have a permanent life policy that allows you to withdraw the cash value without any penalty, there’s an argument to be made for paying down $20,000 of your debt right away and paying off the remainder of your personal loan out of your carefully budgeted income. You’d save a lot of money in interest that way, and you’d get to keep your $5,000 emergency fund.

Which means the real question is whether you need the money in your life insurance policy. Do you have dependents who could benefit from the $20,000 if something were to happen to you? The budget you showed me didn’t appear to include expenses related to a partner or children, but I don’t want to assume.

The other question is why you took out the personal loan in the first place. The answer may be personal, but it’s worth considering. In 2023, you borrowed $30,000, and I’d hate to see you find yourself in a situation where you needed to take out another five-figure loan a year from now.

That’s why I’d still recommend paying off the loan the way you’ve been doing. At 5.75 percent APR and $800 in monthly payments, you’ll clear out your debt in two years and 10 months. It’ll cost you $2,112.11 in interest, which may seem like more than you want to pay, but during that time your $5,000 in savings could accumulate as much as $625 in interest (if you have a high-yield savings account with 4.25 percent APY, for example) and your life insurance mutual fund might be earning a 6 percent return.  

You get to decide what’s best for you, but at least you understand your options.

Is it prudent to have a variety of mutual funds, like a work-provided 401(k)/403(b) and a personal IRA, as well as one or two additional investment accounts? Or is it more efficient to have just one account like the work-provided 403(b)?

Dear Prudent,

Employer-sponsored retirement plans are great. I always recommend signing up for them, especially if you get a company match. These plans allow you to save pre-tax dollars, which allows you to put more of your earnings directly into your retirement fund while simultaneously reducing your tax burden. Yes, you will pay taxes on your withdrawals later on, but many people are in a lower tax bracket by then. More importantly, many employers automatically match your 401(k) or 403(b) contributions up to a certain percentage. As the financial advisers like to say, that’s “free money.” 

That said, these kinds of investment accounts are not at all what you’d consider “efficient.” 401(k) accounts, which are designed to help private-sector employees save for their own retirements, and 403(b) accounts, which are often available to nonprofit employees, teachers, and people who work for the government, can help you set aside money for the future — but in many cases, the types of investments you can make through employer-sponsored accounts are relatively limited. Not only are you tied to the investment provider associated with your employer’s plan, but you may only get to choose from a small number of investment options.

If I recall correctly, I didn’t even get to pick my investments the last time I had a 403(b). The onboarding program asked me to select my risk level — low, medium, or high — and then created a portfolio for me.  

Which is all fine and good, and I still recommend signing up for these kinds of things, but the odds are that you’re going to be invested in funds that may offer lower returns and higher expense ratios than what you might get if you opened your own IRA and created your own portfolio after comparing the options available at various top brokerages.

You can’t do anything about returns, of course — not even if you choose the extremely popular total-market funds that people tend to recommend on investing forums — but you can do something about expense ratios. Basically, investment providers determine in advance how much it’s going to cost you for them to manage the fund; they provide that number in the form of an expense ratio, and you can compare expense ratios before you make investments.

Lower expense ratios are generally better, since you get to keep more of the money you invest. 

However, employer-sponsored retirement plan providers don’t really have an incentive to keep expense ratios low because they know you don’t have any other choice. If your employer’s 403(b) is with a certain provider, you can’t just switch your 403(b) investments to a different provider, so you’re stuck paying whatever the provider decides to charge.

This isn’t to suggest that investing in an employer-sponsored account is a waste of money. Employer-sponsored accounts are great, especially for people who might not otherwise be incentivized to save for retirement. It’s just to hint that putting everything into the employer-sponsored retirement account may not be the most efficient use of your money.

I can’t give you investment advice because I’m not an investment adviser, but I can suggest that you contribute as much as is required into your 403(b) to get the tax break and the company match, and put the rest of your retirement savings into an IRA that you can control. Traditional IRAs allow you to contribute pre-tax dollars and reduce your taxable income during your prime earning years, and Roth IRAs allow you to contribute post-tax dollars and withdraw your contributions (but not your returns) ahead of schedule if you need to. Since IRAs max out at a certain dollar amount per year, you may also want to consider opening a brokerage account that isn’t necessarily tied to retirement and continue your investing journey that way.

It’ll take a little extra time to compare all of the possibilities and make the best choices for your financial situation, but it could be worth it.