Maintaining liquidity as you reduce debt — how a savings account helps

Are you ready to start killing your debt?

Whether you make the minimum payment or you're ready to accelerate your debt repayment like a mad man/mad woman, you need a strategy to make that happen.

Why you need a debt-repayment strategy

While you have to make the minimum payment on your debt each month, what happens if you want to accelerate your payments? If your budget can accommodate it, that's great. You can pay your debt down faster. But what if, at the same time, you have a competing goal like you want to increase your emergency savings fund or you're uncomfortable tying up some of your spare cash because you expect a change of circumstances?

You can put a strategy together to pay off your debt and save at the same time. Interested? Read on…

Think outside the box

Instead of a regular mortgage, my husband and I bought our first house on-contract. And instead of a monthly payment, we paid a lump sum to our house's owner at the beginning of each year (at the owner's request). Because we weren't confident in our ability to leave our savings account untouched — or even to save the proper amount on a monthly basis — we saved up the entire year's payment as quickly as we could. Then, we put the money into a short-term CD that was due to mature the week before our yearly payment was due.

We liked this strategy because the money was harder to access — but, if necessary, we could get to it in an emergency. We also earned a little more in interest by doing it this way.

Debt-repayment, slow and steady

Today, we have a regular ol' mortgage with a regular ol' monthly payment. Most months, we pay about $83 extra, but we want to pay off the mortgage ASAP. We could easily afford to make an extra payment every two months. With some sacrifice, we could double our payment each month.

If that's our goal, why aren't we doing it consistently?

Good question.

We have an emergency fund in place, but sometimes I think about all the emergencies that can happen with three kids … with an old house … not to mention old vehicles.

We don't want to tie up a big chunk of change in our house by accelerating payments if we would get hit by three or four emergencies all at once.

A debt-repayment strategy that maintains liquidity

If you have similar concerns, what about this idea:

Instead of paying two mortgage payments every month, or paying extra on your student loans, why not pay your regular payment to your mortgage holder or student loan servicer first? Then, “pay” your debt repayment savings account with the extra payment. At the end of a year, you could take half of the savings in the debt repayment savings account (or whatever amount you felt comfortable with) and make a dent in your debt.

Another strategy is every so often (quarterly, perhaps?), roll some of the money into a CD (check current CD rates here). You can create a CD ladder and when each CD comes due, you can apply the CD to the debt.

Either way you do this, I see three advantages:

  • You're earning a little bit of interest (precious little, unfortunately, but it's still something) on your money.
  • You're keeping your cash fairly liquid in case of an emergency or an opportunity that may come your way such as rock-bottom stock prices, a low-cost real estate investment, or even buying meat in bulk.
  • You're living on less. When you get used to living on less, you may be able to save more once you are completely out of debt!

This strategy bridges the gap until you can devote all extra money to savings — after your debts have been paid.

Would you ever try something like this for your own debt repayment strategy? Do you think it's too cautious?

More about...Debt

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Kalie @ Pretend to Be Poor
Kalie @ Pretend to Be Poor
4 years ago

I like this idea, especially since it teaches you to live on less while leaving a safety net. I’ve never heard of buying a house on contract. We’re 1 year away from early mortgage payoff, which we’ve done out of our regular checking account, but we’ll take a chunk from our savings account at the end since we won’t need as much saved without a mortgage payment.

lmoot
lmoot
4 years ago

I’m planning to do something similar in paying off my mortgage. Instead of paying extra gradually each month, or waiting to pay it off in full, I’m dividing my payments up into 10 packets of $5k, and giving myself about 2 years to pay it off. When I save 5k, I’ll send it in. This allows me to take advantage of the increased amount that goes towards principle due to the balance being reduced regularly, yet still keep cash on hand in case there’s an emergency, or I feel unsure financially. Right now I am keeping cash for a 0%… Read more »

Michael
Michael
4 years ago

Here are some thoughts: 1. How big is your emergency fund? Will it cover 3 major expenses if needed? If the AC went out, you maxed out your health insurance deductible and you wrecked your car would you be able to cover it with your current emergency fund? My guess is you would need $6,000 for the AC unit, $5,000+ for maximum out of pocket insurance and a $500-$1000 deductible on your car. So if you had $12,000-$15,000 in your emergency fund then you would be good. That is probably about 6 months worth of expenses for most people. Once… Read more »

Gaffer
Gaffer
4 years ago
Reply to  Michael

On what planet is the AC going out an emergency?

cd
cd
4 years ago
Reply to  Gaffer

This reads as really rude. Living in Houston with a 6 month old son, if our AC went out it would be a very big emergency.

saracrewe
saracrewe
4 years ago
Reply to  Gaffer

Some people require AC…in most lives it is not an emergency if there is no AC…but, for example, in mine, even living in a temperate climate, it would be an emergency in the summer, because my seizures are triggered by overheating, which happens very easily in the summer as some of my medication contributes to more easily overheating. So, for us, the AC is required. (Admitting I would look into buying two small window units if I could not afford the $6000 in the example to replace or repair our central air). That is one reason why personal finance IS… Read more »

Dee
Dee
4 years ago

This a good idea, and a nice way to feel safer & more secure while still maximizing the amount being paid toward debts. Thanks!

Joel
Joel
4 years ago

Is it a good idea to use the annual Required Minimum Distributions to pay off the home mortgage?

K-ro
K-ro
4 years ago

This is how I did all my debt reduction — made minimum payments but put extra amounts (and then snowball as I paid off a balance) to a targeted account. This allowed me a savings cushion to draw on for emergencies while still paying off debt on an aggressive schedule. Yes, I paid a little more interest, but all my debt was on very low rates (0-4%) so this didn’t concern me. The reality is that many people got into debt in the first place because they didn’t have an emergency cushion, so financial advisors are right to push the… Read more »

Paul
Paul
4 years ago

This is a pretty one. Similar strategy that I got, the only thing is that I stretch out my debt payment since all of my debts have very very very low interest, like 1.8 percent per year only so it does not hurt and I am making revenues more or less 50% on the loaned amount.

JB
JB
4 years ago

It’s so bizarre that this post went up today because I was just considering doing this very thing. I’ve been overpaying my student loans by $700/month, but I’ve been considering banking the money until I have enough to pay off a whole loan. My thinking is that if I paid off a loan $700 at a time I might save myself $50-100/month when each loan is gone, which is great, but if I got laid off tomorrow I could really use that money. I guess it’s really a matter of feeling secure, because I could wind up saving the money… Read more »

Bryan @ Just One More Year
Bryan @ Just One More Year
4 years ago

This is an interesting idea to save the money in CD’s or savings, then make lump sum payments on the debt. Our approach was to go “all in” with the snowball method by identifying the next debt to payoff and through every extra penny at it until it is gone. You do tend to be very focused and you do gain momentum as debts are paid off. There is also no chance of using the extra money earmarked toward debt to inflate your lifestyle when it is not available. The side benefit is you will save much more in interest… Read more »

Jake
Jake
4 years ago

Whats a good way to calculate how much my emergency fund should be? thanks in advance!

jestjack
jestjack
4 years ago

Good article….the issue that torments me… is it really wise to have your home paid off? Or would it be just as wise or wiser to have the money/equity invested else where? Recently I checked out my Credit Union’s interest rates on mortgage and equity lines. I can borrow money for as little as 2% with amortization of 30 years…with the balance to be paid back in full with a balloon payment in 5-7 years. Well that’s just crazy….I would think this is a “no-brainer”. Borrow the money at 2% and invest it in a mutual fund. Or take the… Read more »

Lisa Aberle
Lisa Aberle
4 years ago
Reply to  jestjack

I can’t make up my mind whether or not we should pay off our mortgage. Is it the smartest financial decision or would it feel best? That’s where I’m at, trying to decide which one I really want.

Michael
Michael
4 years ago
Reply to  jestjack

What you are not including in your calculations is the risk factor. For instance let’s say your house is paid off and in 2003 you took out $50k in a home equity line of credit at 2% with the terms you described. The balloon hits at year 7. Well it just so happens that the market has tanked and your $50k is now only worth $40k (even with dividends reinvested) but you owe the bank $65k and the interest rate has just gone up. If you happen to time the market just right then you could come out ahead but… Read more »

Another Beth
Another Beth
4 years ago
Reply to  jestjack

We’re hoping to pay off our home a few years early. I am looking forward to the day when I can walk in the door and know it’s *mine*. I’m sure someone could crunch numbers and calculate how much more I could save by investing or putting the money in a CD instead of paying off the mortgage. But reducing our recurring monthly expenses sounds like a much better idea to me! We are also used to setting aside the minimum payment, plus extra, every month. When our home is paid off, we’ll just rewrite the mortgage item in our… Read more »

Michael
Michael
4 years ago

Jake – the usual recommendation from financial advisors is to have an emergency fund that will cover 3-6 months of expenses (possibly even up to 12 months depending on your situation). If your job is pretty secure then you may be safe with 3 months. If not you may want to push it to 6-9 or even 12 months depending on your situation. The goal of this money is to help sustain you financially if something unexpected happens. So if you unexpectedly lose a job or face an unexpected health emergency and max out your insurance, you would tap into… Read more »

Mike
Mike
4 years ago

My wife and I are currently paying off her student loan debt while saving for retirement and our next house. We pay extra each month on the student loan debt, and plan to have it paid off in one year. To save for large bills and emergencies we created all kinds of savings accounts in a high-yield online bank. To cover the big annual bills (property tax, car and home insurance) we save 1/12th of the annual payment in separate savings accounts, and to cover un-expected expenses (car and home repair) we have a set amount each month automatically transferred… Read more »

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