Ever 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
- Early Retirement Extreme: I don’t need an emergency fund, I have a credit card
- Faithful With A Few: Do You Really Need An Emergency Fund?
- Cool to be Frugal: Should I Put My Emergency Fund into a Roth IRA?
So, reader, what do you personally think about emergency funds? I’d love to hear your feedback.
Related posts:
- 5 Reasons to Have an Emergency Fund
- Why Spending Money on Life Insurance Trumped Building Up the Emergency Fund
- Are Emergency Savings Necessary?
- Have a Lump Sum? Should You Pay Off the Mortgage Faster or Invest It Instead?
- Should I Go with a Fixed or Variable Rate Mortgage?
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