This post is part 4 of 7 in a series entitled “When not to pay down your mortgage,” which outlines many scenarios where paying extra on your mortgage isn’t necessarily the best financial strategy.
In previous articles, we identified two of the highest priorities in financial planning that should generally be addressed before making extra payments on a mortgage — high-interest debt and employer matches to retirement funds. There is one further high priority that should take precedence over most other investments: preparing for disaster.
Build up an emergency fund
Everyone should have at least 3 to 6 months (and preferably 12 months) of income saved up somewhere in case of some sudden financial need: job loss, major home repair, uncovered medical expenses, whatever. At least 3 months of income should be kept in a relatively liquid state (such as a savings or money market account), so you can access them without a huge amount of trouble when a sudden need arises. The rest of the emergency fund can be put into low-risk investments with guaranteed returns, if you like. A CD may have an early withdrawal penalty, and it may not be a high return, but it gives a little growth in your funds while still guaranteed not to lose value when the market crashes and you just happen to be out of a job and need the money the most.
If you pay down your mortgage before building up your emergency fund, you may find yourself in greater trouble when disaster strikes. You may think the extra equity you have in your home will help you, but it’s not going to be easy to get a home equity loan when you don’t have a job or you have sudden huge expenses that the bank can see which may prevent you from even making regular payments on your original mortgage.
With the emergency money in a savings or investment account, you are free to do with it as you wish, including, for example, continuing to make payments on your mortgage for a year or more when you’re out of work. If all of that money has already gone into your house, and you have no cash reserve, you may end up in a default instead.
That’s not to say that you shouldn’t work toward equity in your home, but after paying down very high interest rate debt (like credit cards), the next priority should usually be establishing a emergency fund in reserve. That will allow much more flexibility in down times than any equity locked up in your house.
Have adequate insurance
Emergency funds are great for dealing with minor disasters, but for serious situations that will cost you more than about 6 months’ worth of income to deal with, you probably need insurance. People with mortgages will already have homeowners insurance, but they may not be adequately insured for other major catastrophes. Life insurance, disability insurance, and long-term care insurance will be incredibly important for covering financial gaps when a spouse or parent dies or is unable to work.
Particularly for parents, a life insurance policy for a few thousand or even a hundred thousand dollars is usually not enough. Be sure that your life insurance and disability insurance are sufficient to keep the household running until children are grown. Most people never need to use term life insurance, and that’s the best-case scenario: you get to be with your kids as they grow up. But what happens if you don’t? It may seem expensive, depending on your age, sex, and health, but it will do a lot more to help your family in the event of a true disaster than just about any other investment.
One important money-saving note about insurance with deductibles: go for a high deductible in most cases. That’s what your emergency fund is for. And that’s why emergency funds and insurance go hand-in-hand. It’s ridiculous to pay to have a $250 deductible for your car insurance instead of a $1,000 or $2,000 deductible when you have tens of thousands in an emergency fund. You can afford better insurance with higher deductibles, and you can afford to have higher deductibles if you have a strong emergency fund. In this case, saving your emergency money will actually help you to afford better insurance at a cheaper rate.
We’ve now identified the three main items you MUST do before even considering paying down your mortgage: (1) pay down higher-interest debt, (2) take advantage of major retirement opportunities like employer matches and significant tax-advantaged accounts, and (3) be prepared for disaster with emergency money and insurance.
If you’ve paid off those high-interest credit cards, you’ve got at least 6 months of emergency money in the bank, and you’re doing at least the full employer match for retirement, it may be time to consider whether overpayment is a good option. However, as we’ll explore in the next couple of posts, there are still other factors to consider.
Disclaimer: This is not intended to be professional financial advice, nor does it apply to all people in all situations. It’s a good idea to consult a professional financial advisor before making any major changes in your finance management, because individual circumstances will often affect the choice of strategy.