Another take on the emergency fund or mortgage pay-down question:
Say you have an internet savings account paying 4 1/4 % and a fixed-rate 4 7/8% mortgage. Say also that you have $100/month that you want to put toward either one. Which would you choose?
Answer? It depends.
There are good reasons for doing either one, or both, and there are situations that you don't want to do either one, or both.
From a pure increase-in-net-worth standpoint, paying down the mortgage is a better deal here, because the mortgage rate is higher than the bank account rate. Leaving taxes/deductions aside for the moment, if the rates were the same, the accrued interest for putting $100 in the bank every month and the additional debt reduction for applying an additiona $100 toward your mortgage would be the same — your increase in net worth is the same. Even including federal income taxes, the increase in net worth would be the same for most people, because the additional income (from the interest) and the reduced mortgage interest deduction (from the additional principal payments) are taxed (or reduced) by an amount equal to your marginal rate.
Heck, inflation doesn't even make a difference here! Either you're depositing money that will depreciate, or you're paying down your mortgage with more expensive dollars.
But there is an advantage to putting the money in a savings account as opposed to paying down a mortgage faster, even if the savings account rate is lower. If it's in the savings account, you can withdraw it and use it. If it's locked up in your equity, you have to borrow it back with a HELOC.
So it might be in fact better to put it in the savings account if you're going to need the money soon, or if you don't have an emergency fund set up. Liquidity is important to have if things turn south for whatever reason.
(By the way, if you want a great savings account, you can score $25 as you get one by letting me know!)
I agree! I think the potential rate for money borrowing is important to consider and often overlooked when people compare "pay loan down" vs "emergency fund" matters.
If folks don't have some easily accessible money in the bank, they are looking at the very real possibility of having to borrow money at a higher rate than the 4.xx they're currently earning interest at <insert online bank of choice> when something comes up.
Here's some food for thought when contemplating the aformentioned topic:
Facts about the Equity in YOUR HOME…
1) No growth— your home is going to
appreciate at the exact same rate whether
you own it free and clear… or you're
mortgaged to the hilt. Your home won't
be worth more when you go to sell it, just
because you've paid your mortgage down,
or paid it off. Which means… the equity
in your home isn't working for you at all!
2) No tax break—the tax break you get
is for mortgage interest you pay—the less
interest you pay, the lower your tax break
3) No liquidity—the only way you can
get your money out is to sell your home,
or refinance or take out a home equity
loan—and if you lose your job or become
disabled, you probably won't qualify for a
loan—your money is locked up in your
home
4) No guarantees—real estate markets
go up, but they also go down—you have
no guarantee the market will be up when
you're ready to sell or how long it will
take to sell
If I told you I had an investment that had: No growth, no tax breaks, no liquidity and no guarantees- how quick would you sign-up for it?
We must avoid at all cost the state of "Under-capitalization" in which most Americans live.
To find out more you may visit my lens at:
http://www.squidoo.com/bankonyourself
One thing to note is that a CD at ING is at 5.25 for 1 or 2 years right now. So if your interest rate is that low, it's pretty much a no-brainer to buy CDs every month (there is only a $1 min) and you'd be better off. So, while not as liquid as a savings account, it would be more liquid than just paying off the mortgage and with a better rate.
Without an emergency fund you could loose your home if you had an emergency. If you send an extra $100 a month in for your mortgage for 5 years, then loose your job – you still owe next months payment. How long will it be before they foreclose – even though you have paid ahead?
It is much better to have money set aside in case of emergencies than to have all your money tied up in your home.
GaryP
http://money-and-investing.dogberrypatch.com/
I agree that an emergency savings account is important (at least $5000) but once this money is in the emergency account, I would stil suggest that you put the $100/month towards paying down the mortgage. If you plan to live in your house for the rest of your life or until you downsize (perhaps in 15 years time), then mortgage paydown, in my opinion is the best way to go. If you need more money than what you have in the emergency account, it is relatively easy to get a part time job on weekends and evenings after your regular job is done (at least in Alberta right now) to raise extra cash.
While you might get more in other investments, for me at least, the peace of mind in knowing that my mortgage will be paid off within the next 10 years is priceless.
Pay off your mortgage in 10 years or less and you will be in great financial shape. Pay it off in 15 years and that is still ok. Any longer than that and you are a slave to a bank.
Great article!
Thanks for all of your comments! I agree that it makes your funds illiquid to pay down your mortgage faster, but if you have a sufficient emergency fund, then it's still a good thing to do to reduce debt.
Pay off the mortgage and forget the savings account especially if you are a higher rate tax payer. Go for an offset mortgage.
Loans on homes can be so low that to pay them off makes little sense, but what can be even lower is some student loans. I held on to mine as long as I could.
If you can obtain a higher savings rate than the mortgage rate go for that instead.