Progress to Date

  • Original Loan Amount: $204,000.00
  • Balance at Beginning of 5-year Goal (1/1/08): $188,983.82 @ 6.00%
  • Balance at Refinance in February 2009: $148,000.00 @ 4.625%
  • Outstanding Balance: $0.00 (PAID IN FULL!!!)
  • Latest Payment Date: April 2011
  • Latest Additional Principal Amount: $17,623.22
  • Amount Ahead of Schedule (since refinance): $121,462
  • Time Ahead of Schedule (since refinance): 7 years 10 months
  • Interest Saved Last Month: $23,972.48
  • Total Interest Saved: $28,435.55 ($1,037.74 on original mortgage; $27,397.81 on current mortgage)
  • Months Remaining in 5-year Goal: 20
  • Average Monthly Principal Needed to Meet Goal: N/A (Goal achieved)
  • Progress List Explained

Saturday, April 9, 2011

Mortgages and Emergency Funds

A widely accepted personal finance "best practice" is the establishment and maintenance of an emergency fund which can be used to cover unexpected expenses, such as appliance failure, car replacement, home repair, or income/job loss. Depending on the source, typical recommendations for emergency fund goals range between six and twenty-four months of living expenses.

As our outstanding mortgage balance is now less than the amount we have saved in our emergency fund, it occurred to me that there is a direct relationship between the two. After a mortgage is gone, monthly expenses will suddenly drop. Therefore, when basing an emergency fund goal relative to future monthly expenses, it's possible to find a point at which it is beneficial to use the emergency fund to pay off the mortgage using the amount of savings which is earmarked for future mortgage payments.

Here's a hypothetical example using nice round numbers. Imagine I have a mortgage with a required monthly payment of $1,000. I also have a goal to have one full year (twelve months) of living expenses covered by an emergency fund. Regardless of my other monthly obligations, if my emergency savings are fully funded, $12,000 of the total saved amount should be allocated to future mortgage payments (twelve months of $1,000 payments). Now assume I have paid enough of my mortgage debt that the outstanding balance is $12,000. It probably makes more sense for me to take the $12,000 out of emergency savings and use that to pay off the rest of the mortgage. If I don't, then I'll end up paying the $12,000 eventually (month by month), but because a portion of my monthly mortgage payment goes toward interest, it will take me more than twelve months to pay off the remaining debt. This means I will end up paying more than a year of extra interest, and my total mortgage expenses (including interest) will exceed $12,000.

Of course, by withdrawing the $12,000 from the emergency fund, I'll miss out on the opportunity to earn interest on my savings. But since an emergency fund will typically be invested in fully liquid cash or money markets (not tied up in CDs or other investments which may need to be sold at a loss on short notice), I'll likely be earning a very low rate on my savings. If the savings rate is less than the mortgage interest rate (also likely), it will provide me a greater financial benefit to get rid of the mortgage right away.

If my required monthly mortgage payment also includes an escrow amount (intended to cover property-related expenses like taxes or interest), it will make it even more favorable for me to pay off the mortgage right away, because less of the monthly mortgage payment will be allocated to principal. So in the example above, it might take me fifteen months to pay off a mortgage with a $1,000 required monthly payment (principal + interest + escrow) if the remaining balance is $12,000. This means I would be on the hook for fifteen months of interest. As for the escrow portion, it's probably a wash -- once the mortgage is paid, my lender will return any accumulated escrow balance to me (the former borrower), which I can drop into my emergency savings, likely earning a higher rate than the pittance which is usually paid on escrow accounts. Of course it will be my responsibility to pay my own taxes and insurance after the mortgage is gone, but if I've been responsible enough to pay off my mortgage, it's probably safe to assume I'll be responsible enough to pay my own taxes and insurance as well.

Since the emergency fund is meant to cover lost income as well as unexpected expenses, I might expose myself to more risk if a sudden major expense were to crop up after I'd used my emergency savings to pay off the mortgage. It's this consideration -- trying to predict the unpredictable -- which keeps my wife and I from immediately using our savings to pay off the rest of our mortgage right away. It is tempting, however. Once the mortgage is gone, we'll be able to replenish our emergency savings in short order. There is a window of time where such a move would leave us vulnerable, though. We're still working on this decision. I'll likely elaborate on this again when we've run some numbers and come to an agreement on how to move forward.

1 comment:

B-Kat said...

I am going to use my emergency fund for the final payout. Not all of it, I will still have 3 months of life covered.

Keeping in mind that with the mortgage gone it frees up $3,430 per month. (monthly payment+lump sum payments) 2 months of savings will put me back at 6 months emergency fund coverage.

It is more a matter of timing for me as my mortgage term is up next Feb. IF it was a few months longer I wouldn't have to use my EF.