On Thursday, I wrote about using a savings account to save up money, then using that amount to pay off a debt. This triggered the following comment:
I’d be interested in hearing the benefits of doing the “savings” account method of paying off the student loan vs paying extra towards principal every month.
Here’s the scoop. Directly comparing prepayment of a loan versus putting money in a savings account and using that to pay off the loan, directly prepaying the loan will always cost less in the long run assuming the loan interest rate is higher than the savings account interest rate.
So why save ahead in a savings account? Why not just directly pay off the loans? The reason is that while the money sits in a savings account, it also functions as an emergency fund so that, in the event that disaster strikes, I don’t have to take out another form of debt to cover the emergency.
Let’s use an example of a $10,000 debt at 10% annual interest over 5 years (basically, a bad car loan). The payments on this loan would be $212.47 a month. If you wanted to get it paid off in two years, though, you need to add another $257 a month to the payment or put $262 a month in a savings account (earning 5.05% APY) and use that balance to pay off the loan in two years.
But let’s say that car’s transmission falls apart halfway through? You have to cough up $3,000 for the transmission (this is a completely hypothetical amount – if you are tempted to shout “but a transmission won’t cost $3,000!” you’re missing the point), but you’ve been paying ahead on the loan instead of using the savings account. Suddenly, you have to dump $3,000 on a credit card at what’s likely a much higher interest rate (if your car loan is at 10%, your credit is probably such that your credit card rate is in the 20s). On the other hand, if you’ve been using the savings account, you can just withdraw the $3,000 from that, pay for the transmission, and you’re in far better shape because you still just have that 10% loan that’s not late at all.
Using the savings account for “prepayments” is a way to have an extra-large emergency fund and still be able to pay off a loan early. It’s not as cost-effective as prepayment in the event that everything goes well, but it can be much more cost effective if disaster strikes. My wife and I like the comfort of having a giant emergency fund for such situations, so we are using this method for debt prepayment.