Emergency fund. Source: http://www.learnmoney.co.uk/banking/bank-07.htmlEver wondered if you should be saving up money in an emergency fund or paying off your debt instead? A long time ago, I looked at whether it was better to pay down your mortgage, or invest the money instead. Today, I’m going to be looking at whether it’s better to keep an emergency fund, or pay down your mortgage instead. While paying off debt is clearly beneficial in the case of credit cards, the case is less clear when it comes to lower cost long-term debt, such as mortgages.

Let’s say you accumulated $8,000 over the last 5 years, and you still have 20 years to go on the mortgage. Is it better to keep this $8,000 as an emergency fund, or is it better to pay off the mortgage?

Scenario 1: No emergency ever actually happens…

Case 1: We keep an emergency fund in the bank.

First, let’s look at the case where no emergency ever actually happens. Here are the assumptions for this scenario:

  • Mortgage rate: 4.5% fixed. I selected this as the rate as mortgage rates are currently low. The higher the mortgage rate, the more the balance will swing toward paying down the mortgage, and vice versa.
  • Mortgage amount: $200,000.
  • Mortgage payment: $1,106.95/month.
  • Bank rate: 3.0% fixed.
  • Taxes are ignored; if considered, there would be less of a return for our emergency fund scenarios, as considerably more of the total value of the fund is comprised of bank interest.
Years from now Action Money Out Money In
0 Invest lump sum at the bank. $8,000.00
20 See how much we have in the bank. $14,566.04
Subtotals $8,000.00 $14,566.04
Net gain $6,566.04

As we can see, investing $8,000 at the bank will give us a total gain of $6,544.04 of interest over 20 years.

Case 2: Paying down the mortgage with our lump sum.

What if we instead take this $8,000, and pay down our mortgage?

Years from now Action Money Out Money In
0 Use lump sum to pay down mortgage. $8,000.00
18 Invest mortgage savings into bank.
20 See how much we have in the bank. $18,075.08
Subtotals $8,000.00 $18,075.08
Net gain $10,075.08

There is a clear advantage of $3,509.04 by paying off our mortgage instead of keeping the money in the bank. I did not count the mortgage payments as “money out” with an offsetting property value as “money in” because we have to pay exactly the same amount in all cases, and it detracts from the clarity of comparison.

Scenario 2: An emergency happens five years out.

Now, the point of an emergency fund is to actually protect us in the case of an emergency. It’s all good and well that we save more money by paying down our mortgage, but that means we’ll have no money if there’s ever an actual emergency. In that case, we would have to borrow the money. If we know that an emergency is going to happen for sure and we have to borrow the money, does paying down the mortgage still make sense?

Let’s say we lose our job for a year and draw down on our emergency fund during that time. Here are the additional assumptions for this scenario:

  • Emergency fund is consumed over 1 year.
  • We find a new job at the end of that year and we are able to pay back at the rate of $500/month.
  • HELOC rate is 5.0%.
  • Credit card rate is 19.5%.
  • I do not take into consideration grace periods for credit card purchases.
Case 1: We keep an emergency fund in the bank, use it, and then replenish it.

First, let’s look at what happens when an emergency actually happens, and we do have our emergency fund ready:

Years from now Action Money Out Money In
0 Invest lump sum at the bank. $8,000.00
5 Withdraw fund over one year. $9,446.74
6 Rebuild emergency fund. $9,092.18
20 See how much we have in the bank. $13,506.71
Subtotals $17,092.18 $22,953.45
Net gain $5,861.27

After five years, our emergency fund would have grown to $9,292.93. As it continues to grow at 3% per year, we are able to withdraw $787.23 per month. After we get a new job and start rebuilding our fund back to $9292.93, we only have to pay a net total of $9,092.18 over around 18 months; the rest comes from interest.

We then leave our fund in the bank until 20 years have passed, and end up with a total of $13,506.71, for a net gain of $5,861.27 overall.

Case 2: We borrow from a HELOC to tide us over during the emergency.
Years from now Action Money Out Money In
0 Use lump sum to pay down mortgage. $8,000.00
5 Borrow from HELOC. $9,446.74
6 Pay down HELOC. $10,115.13
18 Invest mortgage savings into bank.
20 See how much we have in the bank. $18,075.08
Subtotals $18,115.13 $27,521.82
Net gain $9,406.69

We start off by paying down our mortgage as in scenario 1, case 2. When the emergency happens in year 5, we then borrow $787.23 per month from the HELOC to keep things the same as in the previous case. At the end of the year, our HELOC balance is $9,671.46. We then pay the loan down by $500 per month, for total payments of $10,115.13.

We invest our mortgage savings at the end of the year into the bank like in scenario 1, and we end up with an overall net gain of $9,406.69. There is still an advantage of $3,545.52 by paying off our mortgage instead of keeping the money in the bank.

Case 3: We borrow from a credit card to tide us over during the emergency.

What if worst comes to worst, and we have to use a credit card during the emergency? Sounds pretty grim, doesn’t it? Let’s look at the numbers:

Years from now Action Money Out Money In
0 Use lump sum to pay down mortgage. $8,000.00
5 Borrow from credit card. $9,446.74
6 Pay down credit card. $13,145.72
18 Invest mortgage savings into bank.
20 See how much we have in the bank. $18,075.08
Subtotals $21,145.72 $27,521.82
Net gain $6,376.10

Things are worse, but they are not so much worse. By using a credit card, our balance is $10,427.79 when we start working again, and we end up paying a total of $13,145.72 to pay off our balance. The rest is the same as before.

Even when using a credit card to get through the emergency, there is still an advantage of $514.83 by paying down the mortgage. This also assumes that an emergency will happen for sure, that it will last for a year, and that we will have no choice but to use the credit card!

Recommendations and Caveats

Although in this situation I compared paying down the mortgage or keeping an emergency fund, the truth is that you can choose to do both. Where you decide to draw the line will depend on your own situation. I usually keep about 3 months of expenses in cash and I have a varying additional number of months in highly liquid investments.  Beyond that, I prefer to pay down debt or invest the money. What you will prefer to do will depend on your investment strategy.

As a Canadian, higher inflation means higher mortgage rates in the future, and our mortgage interest is not tax deductible. Both of these factors thus also lean toward paying down the mortgage. In general, I believe it is better to pay off debt or invest instead of leaving money sitting at the bank, though it is always good to evaluate your own personal situation and run the numbers.

Before you rush off to dump everything on the mortgage and keep your credit cards handy, here are some questions you should ask yourself:

  • How much equity do I have in my home? Do I qualify for a HELOC? (If so, maybe you should apply for one before the emergency comes, just so you have it ready.)
  • Do I have unemployment insurance or other benefits I can draw upon?
  • What is my credit like? Will I even have access to credit should something come up?
  • How much savings and investments do I have in total? Am I willing and able to use them, should I not have access to credit?
  • What is my own psychological tolerance for risk?

There is nothing wrong with keeping a few thousand at the bank if that’s what helps you sleep at night. Run the numbers, evaluate your own personal situation, and then see how your money will best serve you.

Further reading

So, reader, what do you personally think about emergency funds? I’d love to hear your feedback.

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About

Kevin has left the office, and he is currently fighting the rat race by working on his own business. He enjoys exploring unvisited places around the world and gaining new experiences. He believes that by properly managing our energy and time, we can learn to invest our lives wisely.

64 Comments Kevin on Sep 8th 2010

64 Responses to “Is It Worth It to Have an Emergency Fund, or Should I Pay off My Mortgage Instead?”

  1. I have a sum of money in the bank, and I also have a HELOC. (I love my HELOC.) My emergency fund is probably not as vast as what others have, but that is because my HELOC is kind of my backup plan. (I also have some mutual funds and such too, but I am talking about immediate liquidity.)

    However, not everyone will qualify for a HELOC since home equity has shrunk so much. If that is the case then I would not recommend putting all your spare money into your mortgage.

    • Kevin says:

      Right, Kris, a HELOC isn’t an option for someone without home equity. In that case an emergency fund would be a little more prudent to have, though the credit card is not necessarily a horrible option if you balance the opportunity cost.

      When it comes down to pure psychology, though, if you don’t have much home equity then an emergency fund can work out better for many people, as including the opportunity costs there is not too much of a monetary difference between using a fund and using a credit card, but there is a big psychological difference in spending up money that you saved versus going into debt at 19.5% a year and taking a couple of years to pay it off!

    • Kevin says:

      I just wanted to add that yep, mutual funds etc… are good to have as part of your long-term savings plan, but as their value is highly volatile, they can’t be counted on in an emergency (unless you have hundreds of thousands of dollars or more, then that’s another story), so agree with you there.

      If for nothing else than peace of mind, keeping a few K in the bank and a HELOC on the side might be the best strategy!

  2. I get your point, but I don’t know if the number tell the whole story. Will the HELOC and credit cards be there when you are in a financial mess? For example, they can cut you off almost at will and often do so when you can’t pay the bills (hence an emergency). Also, during a financial emergency, I think the last thing one needs is more debt anyway. However, I am one of those young, risk adverse people I keep reading about :). Kind Regards,
    Shawn

    • Kevin says:

      Of course, everyone’s tolerance for risk is different. It really changes from situation to situation. For example, do you have health coverage? Do you have savings other than an emergency fund? Do you have unemployment insurance? Etc….

      It really depends on where you are in life. It’s always good to look at the numbers and then evaluate your own personal situation and the risks in mind. If it was a question of paying off CC debt I think everyone would agree that paying down the CC debt is more important than keeping an emergency fund. With a mortgage, the case is not so clear cut so it depends more on personal factors, but I think for anyone that has some savings and has some equity in the home, it is an option highly worth considering.

      Thanks for the comment!

      • I think the fundamental difference between the credit card and emergency fund example though is the length of time. For example, most people can get out of CC debt less than 2 years if they cut lifestyle and have an average income. However, most people, even frugal people with decent incomes, typically can only pay off a mortgage after 7 years (average). To go 7 years without having a big unexpected expense would make you somewhat unusual, regardless of whether you have health insurance, unemployment insurance, etc. That’s why I don’t think it is about the initial numbers because these numbers do not factor in risk. If you mathematically adjusted these numbers to reflect the risk of encountering an emergency without an emergency fund, I seriously doubt there would be as much spread as you saw with the initial calculations. Some people would still opt for not having an emergency fund, and that’s fine. I just don’t think these initial numbers tell the whole story.

        • Kevin says:

          In my second scenario, I did assume 100% chance of a $9000 emergency (loss of job) one time, but that’s something I’d actually be interested in reading more about. Have you ever read studies that went into more detail on the risk factor of different situations? How often does the typical family go through unplanned expenses, and what are they like? For those in the US without healthcare insurance, I suppose that some events like having a baby would qualify.

          Personally, if I see $8,000 in the bank, I’m going to use that to reduce my mortgage term. I have life insurance for the really big things like disability, and I also have savings and investments that I can always draw on, and I still try to keep a couple thousand in my checking for liquidity and to avoid the bank fees. Of course, the whole idea of an emergency is that it’s something we can’t necessarily predict, but that’s part of the risks and trade-offs that we make in life.

          Have you ever read about the Smith Maneouvre? In one sense, you can say it’s the reverse of an emergency fund. You basically take out a HELOC for the maximum amount of equity you can withdraw, and invest that in the markets. The idea is that you use the interest expense to reduce your taxes (in Canada, mortgages do not qualify as a deductible expense) and use dividends to pay down your mortgage faster. As a risk-averse guy, I’d love to hear what you think about this. :)

          • Hey Kevin,
            I actually don’t have access to a paper that details the likelihood of particular adverse events. However, they do exist, particularly in specific trades. Just think about insurance: if the company cannot make money on a policy because they have to payout more than they collect, they eventually go out of business. Thus, they mathematically adjust for the “risk” of paying out. I don’t have the background to tell you, off the top of my head, where to go to get the numbers necessary to model this data though. I would guess you would probably have to use national averages and trade publications. However, if the calculations don’t factor in the accurate risk of encountering an emergency, I would argue that they do not have adequate validity in the real world.

            In terms of what are the expenses, they can be numerous. Statistically, we know that medical expenses, credit card expenses, and job losses are the major things that can bring someone to their knees financially. I just think it would be sad to have a nearly paid off house and still go bankrupt because you failed to maintain adequate liquidity. That’s essentially house poor. If you end up borrowing on your house, assuming that you can, then what have you truly gained.

            Additionally, very few people systematically pay off their homes early. Things such as prom dresses, car alternators, job losses, and child births always seem to “get in the way.” Life happens. That’s fine, but it is better if you have a nice big, fat emergency fund when it does.

            Let me say this, I want everyone out of debt probably more than almost anyone. I am debt-free excluding my home and have been for a few years, and it is great. I certainly have no intention to keep my mortgage around for long either. That said, I would lose sleep if I got rid of my emergency fund to accelerate the process. Like I said earlier (& Khaleef reiterated), I am risk adverse. I don’t want my home (or other stuff) yanked from me because my income has dissipated and I don’t have the cash reserves to address my needs.

            Smith Maneuver
            As I suggested earlier, those HELOCs and credits have a nasty tendency to be slashed just when you need them. The last thing one needs during an emergency is to be leveraged up to their eyeballs anyway. Debt is not a tool to get wealthy IMHO and the opinion of the Forbes 400, the 400 richest Americans. That’s good enough for me.

          • Kevin says:

            I completely agree with you on the unplanned expenses. I just went through quite a few medical expenses myself that weren’t all that cheap (before you Americans get mad at me, they were probably still very cheap by your standards), as a significant part of it was not covered by any insurance. However, I simply reduced my savings level for some time.

            I guess it really depends on each personal situation. As you don’t feel comfortable not having a big emergency fund, I actually don’t feel comfortable having one when I could use it to pay off debt. I don’t keep all of my investments locked up, so to be fair, I do have access to some liquid funds that I could convert pretty quickly if need be. Not very much, mind you, as I just paid for a downpayment, but in the past I did have I guess 3 to 6 months of living expenses that could be accounted for in just cash alone. That’s not that much in actual cash, but I can reduce my expenses by quite a bit if need be. Beyond that, I really don’t see the need as I much prefer to pay off the debt. I would see it as wasting an opportunity to keep more than that.

          • Kevin says:

            Woops, hit submit too early. I am also suspect on the use of debt to accelerate earnings, and I find the Smith maneouvre could be quite risky! It offers some advantages, but you better be prepared to ride out the storms.

            I really do think that debt has to be used wisely, and it is not always bad. One place where I wouldn’t mind having debt is on a rental income property that is cash flow positive. There is no need to pay off a mortgage on double duty if your tenants are already paying it for you and you could use the money for something else. Indeed, when me and the girlfriend first started looking for a property, we first looked for a duplex where we could rent out one level. Unfortunately, we couldn’t find one that was simultaneously affordable and worth buying.

            I appreciate the in-depth comments; I really wasn’t thinking that this was a post where there could be such a diversity of opinions. It’s interesting to see how each person approaches this and what their take on it is. I think I’m going to write a follow-up post on this that looks into some of the things that you’ve pointed out, and on the less-visible benefits that you’ve mentioned such as security and peace of mind.

            To be clear, I still believe it’s worth paying down the mortgage rather than keeping a separate emergency fund. I think a few thousand in the checking + relatively liquid investments is fine, and if I get a $10,000 windfall for some reason you can bet I’m going to use it to shorten my mortgage by a couple years. :)

        • Kevin says:

          P.S. Thanks for making me think. I love writing these types of posts as they really bring out vibrant discussion from the readers.

  3. Good analysis. I agree with you that it may seem better to pay off your mortgage and borrow to handle emergencies. However, since the nature of emergencies is that they are unpredictable in both timing and magnitude, it is hard for most people to perform this type of analysis.

    As you said in your summary, it is good to do this type of thinking before making a decision either way. Many people will just read an article or hear a radio program and blindly follow that advice. For instance, someone who doesn’t have a lot of equity or good credit might take this advice and be stuck when an emergency hits. This person should have a large EF.

    On the other hand, someone with a low interest line of credit may do well to have a much smaller EF and plow the rest into debt.

    I guess the real key is to attack debt as much as you can. Personally, I will only have 1 month worth of expenses in my EF until I completely pay off debt.

    Thanks for including my article as well!

    • Kevin says:

      Ha Khaleef,

      Completely agree that someone shouldn’t just take an arbitrary decision without looking at all of the factors; it is a personal decision that depends on personal factors. However, I had to say something given the fact that people don’t always take opportunity costs into consideration when considering things like how much money to put into the emergency fund. ;)

      Thanks for bringing that point up (along with Roshawn and Everyday Tips); I’ve added a couple of points to the post!

    • Kevin says:

      I just wanted to add that I agree with the focus on paying down debt, and the higher the interest rate, the higher the focus. In fact, once I was debt free I think I would be more willing to keep more cash sitting around because then I wouldn’t have a guaranteed return in saving on interest payments. Without debt on my neck, I think having a much larger buffer would be fine, though I would then divert most income toward investments beyond that buffer.

      As far as the mortgage itself goes, I plan to take a balanced approach. Whatever the rates are, we’ll pay it as if it was 6% or even a bit more if we can, but at the same time I still want to invest in the markets for the long term. If the markets stay low for 10 years and then shoot up afterwards, that means 10 years of cheap stocks :)

      • It sounds like we agree on most points.

        Just to clarify my stance. While in debt, I would only have about 1 month of living expenses (plus a $500 buffer in my checking account) saved while I’m in debt. And then I would build up the EF account to probably a year – I’m very risk adverse!

        As you, I like the guaranteed returns of paying off high interest debt. However, with a mortgage since the benefit of paying $10,000 against it is so small (in percentage terms), I wouldn’t do it.

        Knocking a couple of months off of my mortgage isn’t worth having no emergency savings. Especially since homeowners probably have a greater chance of having an emergency – all other things being equal.

        Of course, I’m not that much in favor of mortgages to begin with!

        • Kevin says:

          What if you could knock off a couple years off the mortgage? That’s what the lump sum payment would do. ;) In the USA, you guys have an additional benefit where you can lock in a 30 year fixed at a low rate (you can even do the same with 15 year). In Canada, no such option is available. If one believes that interest rates at current low levels are only temporary, then one is actually not only saving interest on today’s rates, but on future higher rates as well. This is something else to keep in mind.

          I find it very interesting that these situations come up in poker as well. Something about how with large sums (your entire life savings), it’s better to be a bit risk-averse, but with smaller sums (like let’s say, 10% or less of your savings) it can be beneficial to be a bit aggressive! Perhaps we should look at the size of the lump sum in relation to your total net worth? If that $8,000 represents most of what you have, perhaps it’s more prudent to keep it at hand.

  4. Hi Kevin,

    I prefer to dump my free cash flow into the mortgage. In the case of an emergency i will call on the HELOC for backup. It’s as if i lent the cash to my HELOC and took it back in a way except that you might avoid an emergency during and extended period of time and get away by saving a lot of interest on your mortgage.

    I still keep around ~5k in “operational” cash.

    • Kevin says:

      Hi Mich,

      I think my strategy will be similar to yours. Aside from maybe 3-5k in liquidity, I plan to be paying down my mortgage at an accelerated rate as well. I also plan to apply for a HELOC after a year or so has passed, as we should have enough home equity by then (I believe you need at least 25% of equity before applying with the new rules?) Thanks for sharing!

  5. My advice is build up your cash reserves first and don’t rely on borrowing when you have an emergency. Lenders can deny you a loan or cut back on credit card limits whenever they feel like it, especially when economic times get bad.

    • Kevin says:

      Good point, Biz. Credit can dry up when we need it most. I think one has to balance that risk against paying down debt today, and it also helps to have a spread of investments at varying degrees of liquidity and risk variance should credit fail you when you need it.

  6. Mike says:

    Kevin,

    I am a big fan of paying off debt and becoming debt-free. For most people becoming debt free is a process that usually takes many years. I believe a mortgage should be the last thing someone pays off (with paying off credit card and other consumer debt first)

    The thing about having an emergency fund is that we never know when we’ll need that money or how much we will need. Hate to ask but what if you had a almost fatal car accident tomorrow? In this situation cash flow becomes crucial, IMO. This is when most people have to automatically dip into their IRAs, 401ks etc.

    The emergency fund does more than “buy time” should the emergency arise; it pays mental dividends every day. “Knowing” that your have 3-6 months of living expenses taken care of, is a great feeling. I am a bit excessive in this areas as I have well over 12 months in my emergency fund.

    Regarding having the “other investments” take care of a possible emergency. I don’t want to liquidate my stock and bond investments with the possibility of creating unplanned for tax consequences.

    If we go through our working career and never get the “opportunity” to use the emergency fund, we can at some point, convert a portion into our income generating assets.

    Paying off a mortgage and having an emergency fund are both “pillars” of financial independence. However, I’ve never viewed them as an either or. Lastly, consider this: Even if the mortgage is paid off and if you were to lose your job, you would still need money to pay for expenses. You’ve eliminated the mortgage payment but not all of your costs. I know you could draw on investments; however for many people this is when they tend to dip into qualified accounts (401k, IRAs, etc) and end up paying penalties,triggering taxes, etc.

    Here is how I structure my assets so that IF an emergency occurs my investment accounts are in tact. This is because they are long term with the goal of supporting me in retirement. The emergency fund is my “barrier”. The idea is that I never want to have to dip into my qualified and other savings accounts:

    1)Insurances – medical, auto, home, disability
    2)Emergency Fund – more than 12 months
    3) Savings and Investment Accounts (non qualified), – Brokerage, High Interest Checking accounts, etc.
    4)Qualified Investment Accounts – IRAs, 401ks

    Of course this is how I view things. I know you will do fine either way.

    Take Care, Mike

    • Hey Mike,

      I don’t think any emergency fund could take care of the accident unless you’re so rich that you don’t need insurance. I carry auto and life insurance in case of those things. :S

      However, I do get the point you’re trying to make. Peace of mind is something that you cannot measure in dollar terms. I am less risk averse in that I believe that 3 months to 6 months expenses is enough. I usually do have around 2-3 months in cash; I hope I don’t give off the impression that my ideal bank balance is $0 ;) Otherwise I have a couple of highly liquid investments that I don’t mind using and that won’t lead me into tax consequences since we’re not talking about tens of thousands of dollars here. It will be more than that before I have to start touching retirement plans and such.

      Yes, you are right in terms of the “either or”. It is more about the point at which you decide to be. I don’t believe in carrying around tens of thousands of dollars in cash for a “what if” scenario, but that is actually relative. If I had say, $250,000 in assets, then I don’t think having $15,000 in cash would really hurt all that much. Also, if I did not have any debt, I would leave more space for an emergency fund as the opportunity costs of doing so are lower.

      If your expenses are greater, then your “3 to 6 months” will also be greater. If your assets are greater, then the sum doesn’t represent as much of an opportunity cost in relative terms. Maybe because my net asset worth is still so low that $8,000 – $10,000 is quite a large sum to me, and there’s no way I would leave that just sitting there instead of paying off the mortgage. If I had a lot more money behind me, would I feel the same way? Maybe not. Maybe then I would focus more on the peace of mind of having some cash on the side, and that would be more important than opportunity costs when it only accounts for 5% of my assets. I think this could become the subject of another post.

      I like how you’ve structured your “barrier”. Change the emergency fund to 3 months and keep the rest and we’re looking pretty similar. As always, I appreciate your comments!

      • Mike says:

        Hey Kevin,

        The emergency fund wouldn’t be used to cover your medical bills – hopefully your medical and disability insurance would cover that. But even with disability, it typically is only 2/3 of current income.

        Remember, I am 40 and writing from a different perspective (of course, not right or wrong – just different) When you move along in years, you will tend to try to safeguard your IRAs and long term accounts because you can’t recover from a significant hurdle, market loss or whatever the same if you were in your 20s.

        The good thing about different perspectives is that it often provides you with an insight you may have not considered before.

        Good post and good discussion!

        Mike

        • Kevin says:

          Hey Mike,

          I actually pictured you as a younger guy from the photo, I don’t know why! Well that is, the photo before you put Mr. Wise :)

          Perhaps my post deserves a good disclaimer such as “Hey, I’m young and if I fall on my face, I still have time to catch up!”.

          I didn’t imagine that this was a post that would generate a lot of commentary, but I’m glad to hear from different people who have their own perspectives on things. This is what I love about blogging — that it gives you that opportunity.

          • Mike says:

            Most of my so called wisdom just comes from the mistakes I’ve made along my path. Then again, there were times I was too dogmatic in my thinking and needed to consider tweaking my philosophies. I think that’s the take away from this post.

            Today my emergency fund is set to my emotional barometer. I feel comfortable that no matter what, I have plenty of savings tucked away. Your barometer may be where you have it. And that works for you. When I was like 27-28 (It made sense to me) I went out and got 2 jobs paid all my credit cards and put away a lot of cash. I know I am a bit odd in that sense but it also provided a strong backbone for taking risks, like moving for jobs when I normally wouldn’t have.

            As we hit 40 (even though I feel the best I ever have) we tend to consider other types of risk. Income Risk. The inflation risk can be accounted for by owning not just cash but TIPS, high interest savings accounts and other forms of highly liquid assets that are correlated to the CPI (so, don’t let that be a concern) A

            Glad to see the great commenting here on your blog. You’re around 30 comments for this post. Excellent piece!

  7. Dr Dean says:

    Kevin, really love the attention to detail in your analysis. Your site is definitely for personal finance 301, or graduate level.

    My fear with this is that those who are in the beginning of their personal finance education will say, “Kevin says we don’t need an emergency fund.” So they get into a bind.

    If you have all the basics covered with other liquid assets, or a guaranteed place to get money, I am all for paying off the mortgage. I just hope people look at their situation with as much depth as you have!
    Thanks,

    • Kevin says:

      Hi Dr. Dean,

      You are completely right. Through the discussion I have realized that I need to be careful in what I say as people’s situations are not necessarily the same as mine, and though I write from a personal perspective that perhaps includes a lot of hidden variables that don’t come out in a simple post, I have to take that into account. I really hope that nobody thinks that I am saying that they shouldn’t keep any cash on the side at all! :)

  8. Good post Kevin!

    I think one minor omission in the equations above is inflation. That stuff will eat away at cash savings; even those in a HISA (high-interest savings account). Paying down a mortgage gives you instant returns and fights inflation as you continue to build home equity. Over time, that real estate equity will rise; certainly in recent years; to match or exceed inflation. I wouldn’t bother building up a HUGE emergency fund because emergencies shouldn’t happen very often and if they do, better to borrow anyhow. Your argument is well noted.

    That said, my wife and I try to keep a small amount; about $5-8 K in emergency funds. We too, we “cut out” a great deal of expenses if we really needed to in a short-term crunch. I hope we don’t have to. We need our emergency fund because it helps keep our pillows softer.

    I think your last two lines were excellent:
    “There is nothing wrong with keeping a few thousand at the bank if that’s what helps you sleep at night.” “Run the numbers, evaluate your own personal situation, and then see how your money will best serve you.” Great advice.

    • Kevin says:

      That’s a great point! Higher inflation can also results in higher interest rates which will result in higher mortgage costs, so paying down the mortgage now means that much less interest to pay should rates rise.

      You keep 5-8K between the two of you? I guess if I count me and my girlfriend’s discretionary cash it would be similar to that range, though usually shipping off the excess as it comes in. I agree that keeping a large buffer between income and expenses helps a lot, and I would argue it’s even a much more significant safety factor than carrying around an emergency fund.

      Thanks for the comment!

  9. I liked Everyday Tips idea of having the HELOC around for such an emergency. I honestly thought about it (and it’s still a great idea actually), but never got around to it. My father-in-law (who apparently is smarter than I am) does have one too.

    I don’t really have a formal Emergency Fund, but I have assets in different financial vehicles that I could tap into if a true emergency.

    I did take the route of paying extra on my mortgage, and once it was paid off, I’m much less stressed about anything (like of like that guy in Office Space lol).

    The funny thing is that the mortgage rates are now so low, I’m very tempted to buy an extra 200 or 300 square ft house than my current one. I would also like one with a bit larger lawn. :)

    When we built our house, the rates were around 7% (something about a builders loan costing more)… But now since the rates are in the 3 to 4% range, well shoot! Why not.

    • Kevin says:

      Good on you for paying off the mortgage! You must have such a sense of freedom without that hanging on your neck.

      If you can fix a low-rate mortgage for a while, then if the purchase really makes sense for you, then perhaps? To play devil’s advocate, the advantage with long-term low-cost fixed debt is that if inflation picks up, you win.

      I’d personally take that extra cashflow and turn it into something that could spin off income and use it to travel more or something like that :P

  10. I really think it’s important to get OUT of the Emergency Fund thinking. I call this “The Emergency Fund Fallacy” where if you are stuck on this type of thinking, you can’t really drive your wealth.

    • Kevin says:

      I remember that article, Sam. That’s another reason why I tend not to keep large amounts of cash lying around: there are many productive uses to which it can be put, and I will be less tempted to spend it if it’s not just sitting around :P

  11. Sandy L says:

    Really enjoyed this article.

    I’m definitely a type that feels like my money is being wasted when it’s sitting in a checking account making 1% interest. I put loads of extra money into my mortgages every chance I get. I have 1 paid off and 1 to go. Emotional security is huge for me.

    Regarding the comments of “chance of emergency”. We’ve been very lucky to have not had a major emergency in the 10 years since we bought our home. Unplanned expenses on the other hand, there were many. We still didn’t tap into our emergency fund/kids college savings because we bought the house based on 1 income and we had 2.

    Aside from the examples sited above, there are other ways to hedge your bets:
    -Budget based on 1 income, but then have 2 (if you’re a couple)
    -Take out disability insurance and life insurance
    -Budget in a home maintenance fund (we knew we’d be spending $5-$10K/year on our fixer)..when something major broke, it just pushed another project back hence major home repair emergencies weren’t that devastating. In the end, it really wasn’t a surprise when our 30+ year roof needed replacing or that our 50 year old furnace was on it’s last leg. We proactively replaced those things.
    -Budget in a car repair/replace fund

    • Kevin says:

      Hi Sandy,

      In my own personal experience and those of all I know, there also have been no emergencies, except those caused by bad financial planning (like taking out 2 mortgages on your own and consuming the money). The unplanned expenses, of course, can be numerous. I personally try to keep a significant gap between expenses and income so I can buffer it in that way.

      I like the idea that you bought your home based on one income! If we were to go to one income, I could handle it, but I would definitely be living *very* frugally!

      Thanks for sharing your own experiences and for sharing your tips. I think that keeping a healthy gap between expenses and earnings is a very good way to buffer yourself against trouble that may come up in the future!

  12. [...] Using a lump sum to build an emergency fund vs paying off the mortgage. [...]

  13. Hi Kevin,
    Here’s my take: You didn’t take into account that interest rates will not be stable in the future. If they rise, not paying off the mortgage offers a chance for your cash to earn a greater return and the value of the low interest rate loan is worth more.
    My suggestion is not an either/or, but consider paying DOWN the principle a bit while continuing to grow an emergency fund.

    • Kevin says:

      Hi Barb,

      If you can lock your mortgage in at a low rate and hold it there over the entire term, then balancing it out makes sense. In fact, if there is higher inflation in the future, you can even win out by holding on to cheap debt.

      It works the opposite way for us Canadians. Mortgage terms renew every 5 years in general; 15 and 30 year fixed rates are not an option here, and neither is deducting the interest ;)

  14. Andrew says:

    Really interesting dilemma here. Personally, I’d try to do a bit of both…pay off your mortgage but don’t put every last penny into it in case there happens to be an emergency. I’d rather have a little interest collect on my mortgage than be broke in the time of a serious emergency. I think mortgages are a little easier to leave than something like credit card debt.

    • Kevin says:

      Where I live, mortgages are recourse. Don’t pay, and you lose all your assets :O

      I would balance things out too. I wouldn’t do this if I had no other assets or investments at hand. I personally keep some cash and liquid investments on the side.

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  22. Neil says:

    Why can we not do both? I would still advise for the emergency fund due to the fact the piece of mind is priceless!

    ps. you didn’t take in to account the different interest rates on the credit card.

    • Kevin says:

      Hi Neil,

      You’re right, and I would not solely pay down the mortgage nor solely accumulate a large emergency fund. You can do more or less of each depending on your priorities.

      Do you want to elaborate on what you meant by different interest rates? I assumed a rate of 19.5% on the CC.

      Thanks for stopping by!

  23. [...] it Wisely writes about one of my favorite topics   Should I pay down my Mortgage vs Save it in an Emergency Fund. I like this article because the math works in favor of paying down your debt, which I’m [...]

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  27. [...] where you can put your money to work for you! Kevin from Invest It Wisely recently conducted an analysis of whether it is better to put a lump sum of money in an emergency fund or to pay off debt (particularly, a mortgage). The reason for this analysis is because there is an opportunity cost to [...]

  28. [...] responds to an earlier post of mine which compares paying down the mortgage versus holding an emergency fund, and gives us his advice on when paying down the mortgage could be a bad [...]

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